From the November 01, 2011 issue of Futures Magazine • Subscribe!

Stock market trends and the volatility premium

Investing implications

While this analysis is interesting, what’s truly valuable is how it affects your approach to investing and trading. There are important consequences for derivatives investors when it comes to volatility and how it tends to play out in the markets. Volatility is a key measure in the valuation of many derivatives, and its influence is difficult to overstate.

Here are some key findings from this analysis that can be applied in your investment program:

  1. Implied volatility, even when low, often is higher when compared to realized volatility. As mentioned, it might seem that options are cheap in a bull market. Investors often do not sell volatility in these low-volatility environments. In the absence of external shocks, however, the bull markets lead to even lower realized volatility. People would profit from writing options in this case.

    What’s key, though, is that not only does high realized volatility show up more often in absolute terms, but also relative to previous implied volatility, especially on a short-term basis. The extreme events where one-month realized volatility exceeds the previous implied volatility by more than 10% have a much higher frequency.

  2. Chances of a bad surprise where, say, realized volatility is far higher than previously assumed, are much higher if the index trades below the moving average. Volatility clustering describes the observation that large moves in a stock price tend to cluster together. In these cases, it seems that those periods of high volatilities stick together when markets are below the moving average.
  3. Be careful with selling volatility when markets are in panic mode, even when volatilities appear high. It is tempting to sell volatility when market participants are nervous. During these times, options often are trading at relatively high prices, bringing impressive premiums. This often happens as implied volatilities skyrocket after a longer period of low volatilities. It is exceptionally difficult to predict a top correctly during these volatile times, however. As some investors take this opportunity to sell options, the risk of even higher realized volatilities should not be underestimated.

There are many pro-cyclical equity investors using technical analysis and moving averages as a simple tool to follow stock market trends. Given the data we’ve seen here, the equivalent volatility strategy would be to sell short-dated volatility — for example, in the form of short straddles on options with one month maturity with continuous delta hedging or via volatility futures.

Investors betting on continuing upward price trends in the stock market also may consider selling put options. This strategy would allow them to profit from rising stock prices as well as relatively high implied volatilities.

In falling markets, on the other hand, the realized volatility on average does not significantly exceed or fall below the implied volatility. In this case, the data would suggest the investor employ a volatility-neutral strategy, especially considering the skewed distribution and the likelihood of high losses.

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