The relationship between realized volatility and implied volatility is always unique in that it never fully makes sense. Generally speaking we think of implied volatility as the dog and the tail as historical volatility. But, at times, the tail does wag the dog. I can think of numerous instances where implied volatility only moved after a stock or index started moving, like last week. What does the CBOE Volatility Index (VIX) point toward?
Clearly, a week ago Friday, the VIX was pointing toward a major move as it was breaking 22%. Thus, the forward-looking index correctly predicted that we would have a move that would produce back to back 2+ percent moves. Only a week after the VIX hit a 52-week high, the index is sitting at 52-week lows. When we come in today, the VIX will be trading right around 14%.
Yet the before and after can give us a very clear idea. If options traders were properly predicting a move of about 5% out of the cliff, and option traders were predicting the VIX to go back to 14% by Friday, what kind of realized volatility should we see over the 18 days that follow our cliff move? The answer is somewhere right around 12%...if the VIX is perfectly priced. If we accept that the VIX is almost always overpriced, especially when it is low, where does that put realized volatility for the next 16 days or so? Probably closer to 10%
This would still point toward an uptick from what we saw on Thursday and Friday where the market moved at less than 8% annualized volatility. Basically, the VIX may look like a buy at a 52-week low, but it's probably not (if you could buy it), the VX Jan future and certainly the iPath S&P 500 VIX ST Futures ETN (VXX) (which should almost never be purchased) look like terrible trades.
So how should traders take advantage of this "low VIX?" I would point toward a combination of buying and selling. I am willing to venture that there are some opportunities in March options that might be favorable to purchase right now. The March quarterly straddle in the SPX is probably a value at an IV of 13.8%. Even if we do not move that much, I think the decay will be slower than the model predicts as volatile creeps higher. That may be a nice trade.
I would also be looking for opportunities to sell volatility against that SPX straddle. Yen vol has ticked up considerably, maybe it is a sale. Maybe there are stocks out there when the premium is overpriced. Another trade might be to short VXX or VIX options against our SPX trade.
Looking at the Vol ETNs and VIX options themselves...I would not be looking to get long, and in the case of VXX, with the now STEEP contango and spread between Jan VX_F and cash, I think the VXX could have a quick trip back below $25, possibly as early as the end of next week. Certainly by Jan expiration. The safest place to play though might be in February.
In VIX, I am waiting for an expiration play, however, I would point out that there is a huge spread between cash and future, and the 15s are certainly in play. They are ITM in the cash and currently OTM in the future. This should present a great trading opportunity.
Have a great week.
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Mark can be followed on Twitter at twitter.com/OptionPit
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