The rise of implied volatility
Paid subscriber analysis
For the past two-three weeks we have noticed a considerable increase in implied volatility in the options market. What is implied volatility and why is it important for us in particular? And why should you care?
Today we talk about what the options market is telling us about the weeks ahead.
Implied vol
Implied volatility (IV) represents expected volatility of an underlying index (or stock) over the duration of an options contract (before it expires). It is influenced by market expectations over where the index (or stock) might go. In other words it is affected by supply and demand for options. Greater demand for hedging => higher implied vol => higher options prices => hedging more expensive.
Whenever there is a major event coming up (like, e.g., an FOMC speech) implied vol is typically higher, given that there is a higher demand for options to hedge for the event (on the upside or downside; e.g., you are shorting the market, so you buy calls to hedge your shorts; or you are long the market, so you buy puts to hedge your longs). Therefore, every time there is an FOMC event you will see elevated options prices across the curve. The more important investors perceive an event to be, the more demand there is for options, so vol goes up.
What’s the next big event coming up? The US elections, on November 5th. And demand for hedging has been enormous. Investors are piling into VIX calls (which explains elevated VIX levels; from 15 last month to over 20 now), and they are buying SPX calls and puts across the board. Are investors expecting a major sell-off after the elections? Not necessarily. They are mostly just hedging. Hedging through buying options, hence driving their prices and vol up. There is huge demand, so naturally prices are elevated. We therefore have a regime where markets keep going up, but so does implied vol, making it more and more expensive to own hedges (in the form of options).
Now, when you trade short-duration options, like we do at the ORCA BASON Fund, this matters a lot. Why? Because we buy options that expire in the same week. That’s typically when time decay kicks in, so all those elevated prices and elevated vol goes down sharply as we get close to expiration, unless the market moves strongly in our favor. This means that a flat market or a slightly down-trending market kills option premium much faster than usual, so in order to make a profit we need a stronger push up than usual.
That’s why this last week, despite being spot on in our prediction that markets will go up, we got a very subdued move up and made only about 1% gains. In the week before, the price of weeklies was so big on Wed (about 80% to 100% higher than usual) that despite having a correct prediction, there was never any profit to be made, even with the Friday mini-rally (driven by the unemployment report). On any normal week, these would have been two decently profitable weeks.