One of the ways we gain an "edge" in the market selling options is because IV tends to overstate the actual expected move of a stock in nearly all cases. Now we are believers that markets are efficient, in the sense that there is not price edge you can gain picking stocks directionally. But when it comes to option pricing we can prove that selling rich IV has been one of the rare historically and profitable “edges” to trade. The VIX is used to forecast the 30 day future volatility of the S&P 500. In the video above we’ll track the VIX against a chart of the actual realized volatility 30 days from the time of measurement of the VIX. On average, the VIX expected the market to have a slightly more volatile environment than has been realized over the last 8 years. The average difference between the VIX and actual volatility in this period was about 3.25%. So for example, if stock ABC has an expected move of 10% up or down based on current implied volatility then long term the average might actually end up being 8% up or down. IV in this case overstated the move by 2%.
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In today's video, I’m so excited to talk about implied volatility expected moves versus their actual moves over time. One of the ways we can gain an edge in the market selling options is because implied volatility or IV tends to overstate the expected move of stock in nearly all cases long-term.
This is why we are net sellers of options because of this one fact. This is our edge in the market, and we’ve done podcasts and posts and tons of videos about it, but I want to put the nail in the coffin here with this video and show everyone how we know this with empirical evidence.
We are believers that markets are efficient in the sense that there is not a price edge you can gain picking stocks directionally.
This comes down to the fact that there's so much information and markets are priced so efficiently when it comes to the stock price that you can’t gain any edge trying to trade the stock directionally one way or another.
Really stop doing that because even the best companies in the world, the Goldman Sachs, JP Morgan’s of the world can’t even pick stocks directionally, and we've done tutorials and covered case studies on that as well.
But when it comes to option pricing, we can prove that selling rich implied volatility has been one of the rare historical and profitable edges that you can trade.
We’ll use the VIX in today's case study. The VIX is used to forecast the 30-day future volatility of the S&P 500. The S&P 500 is the largest, most widely known and most efficient of all markets out there.
On the next page, we’ll track the VIX against a chart of the actual realized volatility 30 days from the time of measurement of the VIX.
Basically, what we did here is we looked at the VIX on one day and said, “If the implied volatility reading on the VIX is 15%, we want to track over the next 30 days from that measurement if implied volatility was about 15% or 30% or whatever it was. We want to track what the VIX is projecting versus what happened.”
Alright, here's the chart that is powerful in this case study. The first thing you'll notice is that the VIX’s implied volatility, that IV rank or rating for the S&P 500 over the next 30 days is tracking here in this gray line.
The actual implied volatility that was realized once we took that data point over the next 30 days and then overlaid it to see what the differential is tracking here in this red line.
You can see that the vast majority of the time just visually looking at this chart, times like here and times like here and times like here, implied volatility that was expected didn't happen. There were only a few rare instances.
The meltdown in 2008 was one of those instances where actual volatility was more than the market expected. But over the vast majority of the time in the last eight years, the VIX has overestimated what would happen in the market.
On average, the VIX expected the market to have a slightly more volatile environment than had been realized over the last eight years. This average difference between the VIX and what took place in volatility in this period was about 3.25%.
You could chalk that up to being your edge in the market when you trade options. You’ve got an embedded edge here because implied volatility is always going to overstate the expected move.
It's just a natural thing that happens in the market. We don't know about the unknown fear that's coming in the future, and we naturally price in some embedded edge there, and usually, it never happens, or maybe one-time out of eight years, it might happen where we have that fear situation.
Let's look at a stock example with Apple and just use what we already have learned here to project forward what might happen to Apple stock in the future.
Apple stock is currently trading at about 113 as of the time of this recording, and it might be lower or higher than that, and at the time of this recording, the implied volatility which is down here in this red circle is about .3569, so 35.69%.
What the options are currently pricing is that in the future, Apple could have a variance or movement of about 35.69%. What we know from already tracking the VIX and so many other stocks out there over the last couple of years is that this number will always overestimate the actual move in Apple.
If this number is expecting Apple over the next year to maybe make a 35% move in either direction, we might see a 30% move in either direction or even less than that, maybe a 29% or 28% move in either direction.
That number is always overestimating the expected move, and that’s where we get our edge. It’s important to realize that option is buying at this point and paying the IV premium or implied volatility premium is a net loser long-term in any market.
Sure there maybe some great opportunities to do it once in a while, but you have no idea when that's coming, neither do I. No matter how great you are at stock picking, being an option buyer is a net losing strategy long-term.
You have to be an option seller. The only consistent and reliable strategy is the systematic selling of options especially when implied volatility is at extreme levels where our edge is maximized.
We saw that back in the chart of the VIX versus the actual implied volatility. We’ve got to be option sellers more often than we are option buyers.
It's okay to buy options here and there and hedge some positions and we definitely do it, but the vast majority of what we do here at Option Alpha and what I do personally with my portfolio is option selling because of this data that we know is proven behind the realization that implied volatility always overstates the expected move which means that option pricing is always higher than where it should be long-term.
As always, I hope you guys enjoy this video. If you have any comments or questions, please add them right below in the video lesson page.
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