As I was browsing various blog sites I came across an article entitled "What is High Implied Volatility?" at the VIX And More blog. The article is worth a read, and is linked above, but I wanted to mention and elaborate on a simple concept from the article that often gets overlooked. As traders and professors we often instruct students and others about how we can compare implied volatility to historical volatility to see whether an option is over-price or under-priced, assuming that the historical volatility is constant, and that it will stay that way into the future. Of course, comparing the two in real-life without such assumptions can be a little more complex.

As described at VIX and More, we need to compare the current implied volatility with a defined range of either historical volatility or implied volatility. Of importance are the time frames used, the type of past volatility (historical or implied), and the comparison universe (the same stock and/or similar stocks). Furthermore - and this is the key - we must not forget that historical volatility is by definition, and calculation, backward looking. On the other hand, implied volatility is forward looking and considers the market's expectation and potential reaction to news and events, such as earnings, dividends, FDA phase testing results, Federal Reserve actions, etc.

To make life easier, sometimes a relative measure, even one that considers a range or moving average, is useful. For those with a little more background and interests in mathematics and modeling, one of the many variations of the Generalized Autoregressive Conditionally Heteroskedastic (GARCH) models, or stochastic models of implied volatility surfaces, can be used. Other models also exist. I have used GARCH and find it to be useful when constructing option spreads, although parameter selection is necessary. With the right software, even a pre-programed Excel spreadsheet, the analysis can be implemented with less pain than expected, and sometimes incorporated into defined trading rules for those platforms that allow such integration.

Implied volatility has recently decreased on the S&P 500 Index options. As mentioned in Barron's: "This follows the Federal Reserve's decision to finance investment banks, seen by many investors as the equivalent of a massive put option that reduces the future possibility of extremely low stock prices." Many options investors are going cash. The low volatility reduces the premium for selling options, while the recent actions in the market (poor news and little upside, Fed propping up various industries) currently makes both long call and long put options suspect, even with lower prices.

What could cause a change? Many believe either continued poor earnings season, or a drop in consumer spending. In a recent post we discussed the lower returns generated during earning season over the last 5-6 years. Credit Suisse recommends that to hedge against poor corporate earnings, investors should take out a bear spread, buying S&P 500 SPY May 135 puts, while selling May 125 puts. Goldman Sachs gives a similar position bias, but recommends hedging with SPY puts that are 5% out of the money. As mentioned in Barron's, "Those are both good ideas, as GE's earnings shortfall may signal more bad news and rising options volatility."

Tickers: SPY