When I was still new to derivatives trading, a risk manager made a point that’s stuck with me to this day. He said, “something is only ‘cheap’ relative to itself or something else.” This reality is why sales/discounts are such a powerful motivator. The product seems “cheap” relative to itself when it’s 25% off because we’re anchored to the original value.
For the past three months, Nasdaq-100 (NDX) 30-day realized volatility has been higher than the implied volatility of 1-month at-the-money (ATM) NDX options. That relationship (1M IV<1M HV) has been a dominant characteristic of the options market in 2022. It’s highly unusual for implied volatility to consistently trade a discount to realized vols.
Source: LiveVol Pro
The horizontal white line marks the beginning of this calendar year. As you can see, for the preponderance of 2021, the implied volatility for 1M ATM NDX options was higher than the 1M historical vol measures. Translation: over long periods, the implied volatility for index options generally exceeds the historical volatility for the asset over similar time frames.
That tendency gives rise to trading based on implied volatility risk premium (IVRP). A research paper by AQR explains it well.
“The volatility risk premium (VRP) is the compensation that investors earn for providing protection against market losses. In doing so, they are underwriting insurance – primarily option contracts – and with all insurance, the underwriter seeks a risk premium.”
The Nasdaq-100 Volatility Index (VOLQ) is an easy way to track ATM 1M implied vols for NDX. Monday, August 22, was the first day since mid-May that one-month ATM NDX IV (27.3%) was higher than one-month historical vol (26.1%).
Another way VOLQ is useful is as an indicator of expected daily changes in the Nasdaq-100 Index. Volatility is proportionate to the square root of time. There are ~252 trading days in a calendar year, and the square root of that is 15.87.
You can divide the VOLQ Index level (as a percent of 0.273) by 15.87 to get expected daily changes (higher or lower) based on current option prices. So, at present, the options market anticipates +/-1.72% daily moves.
Looking at historical data for 2022, the average daily change for NDX has been +/- 1.70%. There have been 77 sessions where the index closed higher. On average, on those days, the index gained 1.67%. Conversely, there have been 82 sessions where the NDX closed lower. On average, during those sessions, the index declined by 1.74%.
NDX realized volatility has been declining since early June. In fact, 30-day historical vol (26.1%) is the lowest it’s been since late January 2022. More recently the forward-looking implied volatility measures have increased. VOLQ jumped from ~22.5 to over 27 in less than a week.
Will the pop in implied vols hold as we move into September and October which tends to be a turbulent time frame? Will realized volatility measures move back toward 30? Or are we more likely to be witnessing the return of implied volatility risk premium in the NDX option market?
Stay tuned to find out.
Originally Posted August 26, 2022
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