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May 5, 2017

tasty Perspective: Implied vs. Realized Volatility

By:Sage Anderson

Insurance provides "peace of mind," but that feeling of security doesn't come without a cost.

The insurance premiums paid each month on our homes/cars/boats/etc... those help us sleep better at night.

The same can be said about the options market, which is often used for "protective" purposes by investors and traders. Buying puts on a concentrated long position helps provide a feeling of security that if the world falls apart, not all will be lost.

Depending on the investor, risk profile, and approach, this certainly may be the right course of action.

On the other hand, other market participants may look at opportunities in the marketplace from another perspective. Some traders look at the premium paid for "peace of mind" in the financial markets as enhanced returns.

In the same way that insurance companies deal insurance for a tidy profit, some investors/traders with the appropriate risk profile view short premium as a method of increasing returns on their portfolios.

This may be simply by selling covered calls against a long stock position. Or by selling a strangle in an ETF or single stock with an elevated Implied Volatility Rank (IVR).

The basis for this approach is that the market for implied volatility "prices in" a buffer against adverse movement in the underlying securities.

Implied volatility represents the market's expectation for movement in an underlying security. Realized volatility (also referred to as historical volatility), on the other hand, represents how much an underlying actually moved.

Historical data has consistently illustrated that the market tends to overstate expectations related to volatility. Traders deploying a short premium strategy are therefore seeking to exploit that overstatement.

A recent episode of Market Measures reinforces this phenomenon quite clearly.

Using data going back to 2004, tastytrade conducted a study analyzing implied volatility versus realized volatility in the VIX and S&P 500. As you can see in the chart below, the VIX consistently overstated actual movement in the S&P 500:

On average, over the time period of the study, the VIX overstated movement in the S&P 500 by approximately 3.4 points.

Logically, this makes sense due to our understanding of how insurance premiums work. It's essentially a graphical representation of "peace of mind" in financial markets.

When markets are moving a lot, investors will be worried that a large sell-off may be coming soon, and risk premiums get bid. Similarly, when markets are not moving, investors worry it's too quiet, and risk premiums are bid due to anxiety of what might lie around the bend.

It's for these reasons we see the consistent overstatement in the market price for volatility, as compared to what actually comes to pass.

The previously mentioned episode of Market Measures also looks at the implied volatility versus realized volatility in gold (GVX) and the Euro (EUVIX). We recommend watching the full episode for a comprehensive review of this information.

If you have any remaining questions related to implied versus realized volatility we also hope you'll reach out

In the meantime, keep it tasty!

Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

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