In yesterday’s blog I explained why front month volatility does not correlate to the next month out as well as back month volatilities correlate. This lead to a greater question though: Is there a good reason that long term volatility is higher than near term volatility? Take a look at this chart comparing some shrot term implied volatilities to a few longer term implied volatilities:
Long term implied volatility seems to make sense, it tends to trade about 1-2 percent higher than realized volatility, but the near term is almost always below long term implied volatility. Why? There are many reasons floated out there for this phenomenon. Here are three main reasons that I think are strong factors in this occurrence:
People Fear the Unknown
If I ask a person what they are doing tomorrow, they can probably tell me. If I ask someone what they are going to do in a year, the probably do not know. If options are a form of insurance, then just like cars, houses and people, it is much easier to insure the near term of a stock or index than it is the long term.
When it comes to the markets, many traders feel like they have some level of clarity about when and what an earnings announcement might be. They know what economic reports are coming and what those reports might say. Many traders do not feel they have the same clarity on earnings or economics in the long run. Most do not fear a total financial collapse in the next few weeks; however they may fear financial collapse in a year or two years. It’s about predictability and clarity in the short term that causes traders to want to keep front month options less pricy. Because of long term fears, long term volatilities should be higher.
But is that clarity really there? While IV was rallying, there was no foreshadowing of the flash crash prior to it happening, even the day before the crash no one predicted a sell off was going to be that day. Looking at the effects of that crash, traders that were short the near term got blown apart, meanwhile traders that were short long term options ended up not blowing out. One might argue that the absolute nature of the near term options warrants a higher volatility, not a lower volatility.
The Nature of Time Decay
We all know that ATM options lose a large portion of their insurance premium in the final 30 days of trading. If I sell the same out of the money option 12 times, it will collect more premium than if I sell 1 out of the money option 1 year to expiration. Because of this, premium sellers are almost compelled to sell front month options over long term premium. The problem is, almost every trader knows that they should, in theory, sell front month over long term options when implementing a premium selling strategy. This could cause an oversupply of insurance available in front month options. Essentially, because of supply and demand, front month options have a lower volatility.
Here is my issue, most traders never see the final week of trading and fail to really collect on the decay advantage. Yet, those traders will be blown out in those few weeks leading into the final week of trading should an event arise. Could the supply be overselling, and discounting the absolute nature of near term movements?
Volatility is higher than you think
Most traders have heard of compound interest? Most traders have not heard of compound volatility. The truth is that short term volatility implies a lot more movement than one would intially think. If I take a one month15% volatility and extrapolate that volatility to a year, it amounts to a lot more movement than a 15% variance. The compounded monthly vol makes that one month IV a lot closer to long term volatility than it may seem to the untrained eye. Thus, it is possible that front month IV isn't that low at all. It could even be overpriced, in relative terms. This can be confusing and involves a lot of math, but it is a compelling arguement for a volatility contango amoung the months.
This is a really interesting discussion in my eyes, what are you trader's thoughts on front month vs long dated IV's?
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Graphs from LiveVolPro
I would like to thank my friend Tim C. for letting me bounce these ideas off of him.
