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Consistent income trading options: Implied vs. realized volatility

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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.