Is it a Good Time to Buy Options?
by Adam Warner 11/12/09
Free Trading Guides
After about four month's of stagnant action, we have seen a bit of unrest in the volatility cart during the past few weeks.
The following chart shows 30-day implied volatility of the SPDR S&P 500 (SPY) compared with 30-day historical volatility over the past six months. (Each vertical line corresponds to a calendar month from May to November.)
The nickel version of a chart like this is that when the yellow line (implied volatility) is higher than the blue line (historical volatility), then options are overpriced, because the anticipation of future volatility exceeds the reality of actual volatility.
That's how we have traded since the summer until about … now. But it's much tougher than that simple eyeball comparison.
Let me explain.
Implied Volatility vs. Historical Volatility
Implied volatility (IV) looks forward. It is effectively the options "market" estimation for the volatility of the underlying (SPY in this case) over the next 30 calendar days.
Historical (or realized) volatility (HV) measures the volatility of the underlying itself over the past 30 trading days.
So, not only does one look forward and the other backward, the duration of the measure is not even the same (there are about 22 trading days in a typical 30-calendar-day stretch).
But, of course, they are related. Much of options pricing going forward depends on stock action looking backward. In fact, the look back can explain about three-quarters of the pricing going forward.
A good proxy for how options ownership "worked" is to mentally shift that blue line one vertical box to the left. If you buy options at a higher volatility than ultimately gets realized, then you likely lost money (pending the specifics of the trade and how well you managed the position, of course).
Performing this exercise here, we can see that for about three months prior to the start of November, realized volatility hovered between 15 and 17, but, at the same time, options traded for the most part between 20 and 22 volatility.
By and large, if you owned options under those conditions, you lost money either via opportunity cost (straight stock ownership worked better) or just pure losses (say, owning straddles that did not work well enough).
That's all in the past though. What about now?
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