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Consistent income trading options: Implied vs. realized volatility

Implied vs. realized volatility
Implied vs. realized volatilityOptionsAnnex.com

In our quest to understand trading options for income, we often question how accurate is IV (implied volatility) for the S&P 500, which is provided by the VIX. This article attempts to answer that question by comparing the 1 SD (standard deviation) expected move with the realized move (or actual move) of the SPX (the index for the S&P 500).

The 1 SD expected move (EM) is derived from the VIX using the following formula: 1 SD EM = SPX Price x VIX x SqRt(days/365).

To determine the accuracy of the VIX, we can compare the average daily realized move as a percentage of the EM over various periods. Tasty Trade recently performed this test by looking back 10 years, 5 years, 1 year, and 1 month from two dates: June 2014; and August 2012. In addition, Tasty Trade took the latter date and projected forward 2 months, 6 months, and 1 year to compare the average percentage of EM over those time-frames.

The results: in all cases, the VIX overstated realized IV as shown by the percent of realized being below 100. The shorter the time-frame, the greater the overstatement (10 year 74% vs. 1 month 47%). The figures for June 2014 and August 2012 are comparable except for 1 month (June 47% vs. August 55%). Looking forward in August 2012, all periods again showed that the VIX overstated realized IV (2 months 61%; 6 months 63%; 1 year 71%).

In conclusion, if the VIX is overstating IV, then the premium received as a seller of options is also overstated. It is interesting to note that the longer the time-frame (whether looking back or looking forward), the less the overstatement; this indicates that shorter the time-frame, the higher the average overstatement of premium.

You can take advantage of this information in two ways: First, by using shorter DTEs (i.e., Weekly vs. Monthly options); and second, by going to lower SDs during low IV environments (i.e., from 2 SD to 1.5 SD).

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.