Accuracy Of Market Estimates of Volatility

In a couple of recent posts viz, Is It Better To Buy Or Sell Options? and Buy/Sell Musings & Volatility, I've been looking at the trader's bias of being a either a buyer or seller of options, or at least being nett short or long gamma.

The conclusion I have reached, for whatever that is worth, is that the decision generically boils down to volatility. That is to say that the trader must examine the volatility priced into the option, AKA implied volatility, and decide whether the price is at, over, or under the odds; or in option parlance, whether the option is fair value, over, or undervalued.

Some writers suggest a comparison to historical volatility, but I wrote in Buy/Sell Musings & Volatility that I thought that was naive and an inappropriate way of determining relative value. Implied volatility looks forward; it is the collective markets guestimate of the volatility it thinks will be realized in the future, in other words the market's view of correct value for that option. It is not definitive, cannot be definitive, because we don't know what will happen in the future.

Historical volatility is definitive however because it measures actual prices traded in the market place over a set of past data of the analyst's choosing. This can be any period, but most commonly over the preceding 20 or 30 days of data. For the purposes of this article I am going to use 20 day historical volatility as this represents the approximate number of trading days in one month.

The VIX is an index of near term implied volatility on S&P 500 options and is quoted according to a formula, to smooth out implications of impending expiry etc. Details and method of calculation are available from the CBOE at this LINK. Essentially it is recording implied volatility one month henceforth.

As I have stressed up til now, it looks at past data, whereas implied volatility looks forward and what happens in the next 20 trading days may be vastly different to what happened on the last 20 trading days, volatility wise. It does have it's uses however. It allows the analyst to examine the 'normal' range of actual volatility for an underlying instrument, how it's cycles, what has been its upper and lower boundaries under various market conditions etc.

Historic volatility has a further use. We can use it to measure how accurately the market forecast one month volatility by looking at the actual volatility realized in on month's time, via the historical volatility calculation.

Let's have a look at the S&P500 using VIX as proxy for implied volatility available at a given date and realized volatility one month later.

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As we can see in the above graphic, on the 1st of Feb the market overestimated volatility substantially, therefore we can say that on that date and with the benefit of hindsight, we would have been better to have been a seller of options, all other considerations aside.

Manipulating the historical volatility plot backwards by one month makes it easier to analyze by lining up the implied volatility with the volatility realized in one month later.

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In the data that we can see in this graphic, the market collectively forecast volatility correctly, finally, in about the third week of March. So we can say, again with the benefit of hindsight, that S&P500 options at that point were fair value, though it is only today, one month later, that we can say that.

The displaced historical volatility plot gives us the opportunity to view the implied volatility at any point in the past and also in toto, to see how well the market forecasts volatility over the long term. The graphic below shows, on SPX options at least, that the market tends to over estimate forward volatility chronically.

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That is it overestimates future volatility until it doesn't. Sellers at market tops get taken to the woodshed.

This evokes the 'picking up pennies in front of a steamroller' cliche for put sellers and synthetic equivalents (buy/write traders) and bull put traders. Put buyers who successfully pick tops score a big time try/touchdown/<or goal scoring nomenclature appropriate for your country> with the vega bomb that blew up in the seller's face. (With apologies for mixing metaphors there)

As intimated in the preceding paragraph, of course being short or long options is not the only consideration. Delta, gamma and theta also cohort the make the trade; or wreck it as the case may be. In markets swoons put buyers will be celebrating with festive dinners, Dom Perignon and Cuban cigars while quite obviously call buyers will be drowning their sorrows with rough red, despite being on the correct side of the buy/sell divide.

The overriding point here however is that market estimations of volatility aren't very accurate and I believe an edge can be obtained by being a better forecaster of volatility and I believe such analysis can help traders make better option trading decisions and not be stuck in a permanent buy or sell paradigm.

Buy/Sell Musings & Volatility

In a recent post I was discussing the question of whether it is generally better to be a buyer or seller of options. My conclusion was that theoretically there is no inherent advantage in either buying or selling, if options are priced correctly; it depends on the situation.

The oft repeated mantra out there in options land is to sell when options are overpriced and to buy when underpriced. Wise advice, but of course the sixty four thousand dollar question is - when is an option overpriced and when is it underpriced?

Of course if you know your option theory, you'll know the great variable in option pricing is volatility, all other inputs being known definitively.

We can measure the volatility of the underlying by looking back over a set number of days and applying a formula to determine the statistical volatility over that time frame. This is also definitive, but unfortunately may bear no relation to the volatility realized over the same number of days henceforth.

This is the volatility option traders want to know, future volatility. As it lies in the future, it cannot be known. Therefore the market collectively makes a forecast of future volatility and prices options accordingly, hence the measure derived by a little bit of algebra, 'implied volatility'.

Some folks suggest comparing implied volatility to statistical volatility to determine over or under valuation. I say that's naive. As discussed, statistical volatility looks backward, but implied volatility looks forward and as I've already pointed out, the volatility realized going forward can be markedly different to the preceding period.

What the individual trader must therefore do, is to make a call on future volatility and decide whether options are fairly valued or not, according to his or her own projections. Statistical volatility may be a tool that can be used in this analysis, but ultimately he who guesses best, wins.

Of course there are other dynamics at play depending on the specific strategy which may sink or save any one position, but good forecasters of volatility have a huge edge.

In the next post, I want to have a look at how accurately 'the market' forecasts volatility.

80% Percent of Options Expire Worthless?

It comes in several flavours, sometimes stated as 80%, 90%, or whatever. It is the maxim that most options expire worthless. It is repeated so often out there in the marketplace, it is taken as a given and used as a justification to be a nett seller of options and/or promote option selling @education". It is repeated, as a mantra, by some of the most well known folks in optionland. There is only one problem, it's bullshit.

I like being a nett seller of options too, but the reason has nothing to do with the statistic of how many options expire worthless. As I sated in my previous post, it rather depends what strike one sells that dictates the probability of an option expiring out of the money. I like selling options for mostly psychological reasons; what I do has evolved mostly because of my personality direction picking prowess (poor) and how I like to trade.

Let's look at the actual figures according to the Chicago Board Options Exchange:

About 10% of options are exercised during each cycle. That means the other 90% must expire worthless, right?

Wrong! In fact over 60% of all options are traded out in the marketplace before expiry. These could be in, out or at the money.

That leaves approximately 30% of options expire that expire worthless in each monthly cycle.

Can anything be gleaned from this regarding being a buyer or seller? Absolutely not, there are so many different  strikes, strategies and combinations which are not given in this statistic that further analysis is impossible.

Is It Better To Buy Or Sell Options?

This is the question perpetually asked by retail option traders, often having been tainted by BS from some hyped up moron on a stage. I guess the question in their mind is over the long term,whether the negative theta of long options is too costly to be overcome by the long gamma and therefore it is better to sell options and take the other side of the equation.

In this simplest form it ignores volatility and presupposes that one should 'always' be either a seller or a buyer.

Professionals rightly point out that if options are correctly priced, there is no long term advantage in either buying or selling options. In my experience as a retail trader of some length of time, I am quite prepared to accept that as broadly true.

However, most retail traders, seem to fall on the side of selling options, or rather being nett short premium and short gamma at inception at least. Certainly a short gamma strategy where the short strike(s) are somewhat out of the money will have a higher than 50% win rate, which makes it 'feel' like it's a better way to go. However the win rate is irrelevant if the relatively fewer but higher losses, outweigh the more numerous but smaller wins.

Sometimes it can take neophyte option traders some time and a bend at the end of the trend to realize this.

Perhaps the most absurd reason I have seen is the claim that "80% of all options expire worthless", so it is much better to sell than to buy. Apart from this being at worst complete bollocks and at best a misrepresentation, it is irrelevant as discussed above. The actual figures I will detail in another post, but let's put our thinking caps on here.

Supposing XYZ is trading at $50 and I sell a $40 put, is there an 80% chance of the put expiring worthless? That's entirely possible, but what if I sold the call instead? Is there also an 80% chance of the call expiring worthless?

 Of course not.

What if I sell the ATM $50 put or call? There would be about a 50% chance wouldn't there? I could belabour this point further, but you get the point that chance of expiring worthless is dependent on several factors.

The question of whether to be a buyer or seller, if the question is couched in terms of always being a buyer or a seller, is the wrong question in my view. It is often asked because neophytes fall in love with a particular strategy and try to impose it onto every market condition. An example of this are the traders that have been sold a course on bull put spreads or covered calls and try to trade that strategy at all times. Real life invariably teaches these people that these strategies, though perfectly good strategies when appropriate, do not fit every market condition.

The question I want to ask is - What is the best strategy right now, at this point in time, for this particular market?

Before that can be answered, one must have a view of direction, volatility and the possible magnitude of changes in these. An understanding of how it might be if it blows up in your face is also essential.

Therefore the answer to the question posed is - it depends.