the option market's point spread
Part I of a discussion of VRP
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Friends,
The volatility risk premium (VRP) is the notion that options are generally overpriced. Not all the time, not in every name, not across the entire surface. Just in general.
What to do with this information is another matter.
If their premiums are higher than their cost to replicate you can sell them, hedge, and earn a profit. If the expected value of owning an option is negative you can still buy them to make an existing portfolio safer. The combination can be a better proposition than looking at any of the line items in isolation.
Either way, we want to separate price from value.
In Primer #8: Top of the Funnel: Cross-Sectional Fair Value, I define how moontower.ai computes VRP but we’ll use a slightly simpler computation for this post:
VRP = 1-month implied vol (IV) / 1-month realized volatility
The implied volatility is “constant maturity”. This means we interpolate between the 2 closest expiries which surround 30 calendar days into the future. The interpolation is linear in log(time). Or you can linearly interpolate variance (ie volatility squared) and convert back to volatility. Same thing.
The 1-month realized vol for this post is simply the sample standard deviation of the last 20 daily logreturns annualized by √251
If implied volatility is 20% and the realized volatility is 15% then the VRP is 20% / 15% or 1.33.
In the moontower tools we’d refer to this as 33% or VRP - 1 to represent it as premium/discount.
If the implied vol was only 14% then the VRP is 14%/15% - 1 = -6.7%
Forward-looking vs backward looking
Implied volatility is set by market consensus. It’s the number that makes an option model spit out the price for calls and puts that actually trade. It’s both forward and backward looking.
It’s backward-looking because traders use history to handicap what volatility can be. SPY and TSLA behave differently. You’d love to buy TSLA options for SPY implieds and sell SPY options at TSLA implieds. In fact you’d pay for the privilege. So would everyone else. Your bid price to this is a pairwise microcosm of how the options surfaces in the world arrange themselves in a giant, relative matrix. Much of that matrix is pulling from how these assets move and co-move. That’s historical info.
Right now, is a great example of how option markets are also forward-looking. With the US elections approaching, there is an outsize chunk of 1-day variance waving to us from nearly every option term structure. This is TLT with the maturity dominated by the election highlighted:
This volatility is less driven by the past moves. a projection of past moves is blended with an estimate of how much bonds might move on election day.
💡See Understanding Implied Forwards to learn more about the blending.
This highlights the tension of VRP ratios. The numerator knows things the denominator doesn’t.
From the Primer:
The VRP ratio divides IV, a forward-looking measure, by a lagging realized volatility. We understand both the embedded utility of such a measure —vol clusters, so recent volatility is correlated to the expected future volatility; and the tension that the numerator anticipates the future while the denominator reports the past. But there is a wrinkle around known events that distort our interpretation of the measure. The following examples characterize the distortion:
1) Upcoming earnings or FOMC day
Implied volatility will anticipate the extra variance associated with the upcoming event, artificially widening the VRP. Professional option traders will use quantitative methods to extract how much extra variance the market is assigning to the event to “clean” the IV. Ideally, VRPs would be adjusted for known events. There is no single accepted technique for cleaning the IV but the quick solution is a judgment — “XYZ has an abnormally high VRP, but I just noticed it has earnings next Tuesday”. [The moontower.ai roadmap includes providing a calculator to allow a user to extract an event. In the meantime, you can use term structure tools (described later) to “see” where the market anticipates events]
2) Earnings have recently been reported
This is the opposite failure mode of the VRP measure. A stock had a large earnings move which carries significant weight in the realized volatility (the denominator of VRP) but the IV is looking forward to a period where there is no news expected since the company has already given guidance, had a conference call, and reported financials. This will artificially depress the VRP. Again, judgment is in order. It’s best to compare the IV to periods of realized vol without the earnings move.
Quants have spent many a brain cell trying to forecast volatility. For good reason. If your forecast is better than the one embedded in the implied, you could Doordash Sizzler like a boss.
In the moontower.ai tools we can see how well the implieds predict the realized vol.
This is double-paned chart is XBI 30d IV vs 30d realized vol. The top panel shows how the implied vol is usually a bit rich to the realized but not always.
In the bottom panel, we toggle “Lag IV”.
This lags the implied vol so we can see how IV tracked the ensuing realized vol. You are looking at the realized vol next to what the implied vol was a month ago (hence the “lag”).
The red box on the chart is August 5th. The realized vol naturally shot well over the IV from a month earlier (in other words, if you bought XBI options in in July they were cheap compared to the movement August 5th had in store). In addition, the top panel shows how IV itself also shot up on August 5th. But as you look back at the bottom panel, you can see how that elevated vol turned out to be much higher than the realized vol that unfolded the remainder of August as the stress seemed to depart as quickly as it showed up.
For the rest of today we will examine data from the past year to get a feel for the VRP in lots of tickers. VRP is a popular topic in options, you’ll want to understand its shape.
It’s the option market’s point spread.