Seller beware. That is an unusual warning, but it applies right now to the options market. Sellers of protection against large price moves have been pocketing gains. But many will suffer losses if markets become less calm.
Market torpor ( 1. A state of mental or physical inactivity or insensibility. 2. Lethargy; apathy. See Synonyms at lethargy.) has reached historic proportions. One measure is implied volatility, which encapsulates investors’ expectations of how much a particular market will move over a set period. The VIX index of expected U.S. equity volatility hit seven-year lows near 10 percent on July 3. CBOE Volatility Index A mathematical measure of the implied volatility of options trading on the S&P 500 index. That is, the CBOE Volatility Index attempts to measure the likelihood of option prices to vary unpredictably in the context of a particular pricing model in this case, the Black-Scholes model. A higher number on the index represents greater volatility, while a lower number represents lower volatility. While critics maintain that its usefulness is overstated, the index is considered a leading indicator of option volatility in the wider market. The CBOE Index is operated by the Chicago Board of Options Exchange, and is also known as the VIX. VIX Index An equity volatility measure developed in 1993 by the Chicago Board Options Exchange. The index is calculated using eight S&P 100 (OEX) option contracts, four calls and four puts, with an average time to maturity of 30 days. Many traders use the VIX as a general measure of index option volatility. Also called CBOE Volatility Index. Implied volatility The expected volatility in a stock's return derived from its option price, maturity date, exercise price, and riskless rate of return, using an option pricing model such as Black-Scholes. Implied Volatility What Does Implied Volatility Mean? The estimated volatility of the price of a security. Investopedia explains Implied Volatility In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets. In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option's premium. IV can be derived from a model such as the Black Scholes Model. Implied volatility sometimes is referred to as vols. The MOVE index of implied one-month volatility in Treasuries is at 55, near all-time lows just below 50.
The obvious reason for the declines in implied volatility is a sharp fall in actual volatility. Options traders basically expect the immediate future to look much like the recent past. But something else may also be responsible. Some investors are using the options market as a source of revenue.
Options are a sort of insurance. The revenue that options sellers receive for offering protection against large adverse market moves is a premium. That premium juices up the meagre yields available in today’s markets. As long as asset prices stay reasonably stable, the insurance policies don’t have to pay out anything.
Giant asset manager Pimco has said it has been selling such insurance to pick up yield, a practice known as selling volatility. It is unlikely to be alone, as the narrowing gap between implied and historical volatility in many major currencies suggests.
Implied volatility is typically higher than recent historic volatility, as sellers of volatility add a sort of uncertainty surcharge, a compensation for the risk of being wrong. The amount they can add depends on the balance of sellers and buyers. As the number of volatility sellers increases, the gap tends to narrow.
This has been happening in several major currency pairs. The difference between one-month implied and historical volatility is a half or less of mid-March levels in euro/dollar, dollar/yen, and sterling/dollar.
Investors may be tempted to accept a shrinking volatility risk premium out of a combination of desperation for higher returns and hope that market perma-calm will persist. B
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