Volatility
Like

Is Volatility Gone… or Just Forgotten?

Richard Croft
September 26, 2016
2689 Views
0 Comments
6 minutes read
Is Volatility Gone… or Just Forgotten?

In an environment where we see sluggish growth among industrialized countries, global deflation, weak oil prices, political indecision in the US and negative interest rates, one could argue we are living in the worst of times. Add to that mix company specific events like missed earnings and questionable government regulation and we have a classic tug of war between bulls and bears. More worrisome to me is the undue influence that company specific events are having on the broader market.

I say that because one would think in such an uncertain environment that option writers would be generating well above average returns. No so much! Mainly because uncertainty in the broader markets and even among the sectors, is not being translated into higher option premiums. Leading one to ask, is volatility gone, or just forgotten?

The Canadian Volatility Index (symbol VIXC) closed Friday at 12.73 near all-time lows and 30% below its 200 day moving average. The VIXC measures the volatility being implied by a cross-section of options on the S&P/TSX 60 index. A low VIXC implies low option premiums, a higher the VIXC; more expensive options. How can volatility be so low with so much global uncertainty?

Before we examine that, it is important to review the ground rules. Traders need to understand that there are six basic components within the option pricing equation. Most importantly is the relationship between the strike price of the option and the current price of the underlying stock. Are we, for example, trying to value an in, at, or out-of-the-money option?

We also plug into the formula, the time to expiration. The longer the option has to expiry, the more value it has. Keeping with the time to expiry theme, traders need to be able to value the cost of carry associated with competing option positions. Cost of carry brings dividends paid (if any) and the risk free rate of interest into the model.

Finally, we plug into the formula an assumption about volatility. The more volatile the underlying stock or index, the better the chance that it will move in the direction necessary for the option to become profitable.

Volatility is seen as the most important consideration when pricing an option because it is the only factor in the pricing model not given, and therefore, must be estimated. In many cases, traders plug all the factors into the formula including the current price of the option. Rather than asking for a theoretical fair value for the option the formula solves for volatility… referred to as the options implied volatility.

Implied volatility is simply the option market’s attempt to quantify the risk given current market conditions. Presumably, the greater the uncertainty, the higher the implied volatility which by extension, means higher option premiums. In the current environment we are witnessing a serious disconnect between option premiums and uncertainty. At least among index options.

Normally such disconnects precede a major market move one way or the other because option traders are notorious at underestimating future volatility. Often bidding up premiums too far after a major move or driving premiums too low during periods of market consolidation. The easiest thing is to dismiss the current disconnect as simply another case of traders misdiagnosing the market. However, it may be more than that.

When you think about option premiums and how it reflects risk, you can break that down into three components; market, sector and company specific risk. Because the S&P/TSX 60 index represents a broadly based portfolio, it is only measuring market risk.

Specific sectors are less diversified, and reflect both market risk and sector risk. We would expect premiums on sector indexes to be higher than would be the case for more broadly diversified market indexes. We see that differential play out in sectors like energy and precious metals. That said, even among sector indices, we are seeing historically low levels of implied volatility.

What appears to be happening is that investors are shifting attention to company specific issues. The implication is that we are in an environment where company selection is significantly more important than market direction. I say that because investors seem to be willing to pay up for options on individual companies, believing that company specific events will dictate market movement over the near term. Something that historically at least, is not consistent with longer term trends.

That leads me to think that the future will sting investors with a significant market move – up or down – that will shift attention away from individual companies and back into the broader market or specific sectors.

In the interim may I humbly suggest that you review your positions and at the very least make certain that your current portfolio of individual stocks is hedged and diversified?

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

191 posts
0 comments

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Scroll Up