Year-End 2010: Looking Backward and Forward (in Volatility Terms)

Volatility for an options trader can basically mean two different things. There is historical volatility and implied volatility.

Actual historical volatility is the objective measurement of the past movement of a security expressed in annualized terms. Typically, this compares prices on a close-to-close basis. It is usually different for different time periods. For example, the 30-day historical volatility of the S&P 500 Index (SPX) is 11.5% currently. The 100-day actual vol has been 14.5%. And the last ten days? The actual 10-day historical vol is 4.15%. That certainly paints a picture that the market (in recent sessions) has not been moving much at all.

The other type of volatility is the implied volatility that is calculated from the option prices in the market. The CBOE Market Volatility Index (VIX) reading is the most-often cited indicator of where implied volatility is for the overall market. The VIX is derived from the matrix of prices in the SPX cash index options. The VIX is currently at 17.87%, up a bit after hitting its lows for the year in late December.

So the implied vol is down but the actual movement in the market is close to zero. When I think about this in relation to how far (in price terms) the market has recovered from its lows of the summer, I can see good reason for the recent pop in implied vol levels.

The market is up more than 22% from the July lows! Some individual equities have triple-digit percentage gains this year! For example, Netflix NFLX is up 233% this year, Crocs CROX is up 205%, and Chipotle CMG has surged 149% in 2010. You have to think that being short vol (options) at these reduced levels with the market up at these current high levels is not providing the same risk/reward profile that was present three or four months ago. Couple that with the increasing bullish sentiment and it could make contrarians very nervous.

Traders tend to be pack animals. Popular strategies tend to chase the trends that have been working. This makes sense on many levels but I like to try and keep my mind open to the chance that what has been working may suddenly change. I am not recommending any course of action other than encouraging all traders to take an additional look at the risk/reward profiles of strategies that are dependent on the market continuing to remain stagnant. What happens if that doesn't hold true.

Remain disciplined in your trading.

Thank you for making 2010 a great trading year.

Here's to a prosperous 2011!

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