Compare Historical Volatility And Implied Volatility

When a high option premium roughly matches stock volatility, we can expect premium to stay high so long as stock volatility does not change. A change in stock volatility can be expected to work a change in option prices in this case, since the option price (and therefore IV) basically is tracking stock volatility.

The following example that illustrates historical and implied volatilities for Lehman Bros. (LEH) on September 24, 2007, when it was $62.70 per share:

           Figure 5.12

Underpriced Options

Historical and Implied Volatilities:

LEH – $62.70

Call Strike October 2007

Call I.V.

Current Hist. Vol.

10/30

30 Days Ago H.V.

10/30

60 38% 56% / 58% 82% / 60%
65 36% 56% / 58% 82% / 60%
70 36% 56% / 58% 82% / 60%

In Figure 5.12 historical volatilities are given for 10- and 30-day periods, both when the table was compiled and as of 30 days previously.

Note that current historical volatilities range from 56% to 58%, yet implied volatilities for the three calls closest to the money run from 36%-38%, which is significantly lower than the historical volatilities. When option IV is significantly lower than stock volatility, the fact is that the options truly can be said to be underpriced. While underpriced options appeal to the option buyer, they are of little use to the option seller. For covered call writers, underpriced options simply mean we are not being paid for the stock’s actual volatility!

Interestingly, LEH options’ implied volatility was high enough to put them on lists of the highest covered call returns, even though their implied volatilities were 1) far lower than LEH’s actual volatility and 2) lower than for many other companies appearing on these lists.

But sometimes high premium does mean high IV. Let’s now compare IV and volatility data taken the same date for Intuitive Surgical (ISRG) at $221.91 in Figure 5.13:

             Figure 5.13

Overpriced Options

Historical and Implied Volatilities:

ISRG – $221.91

Call Strike October 2007

Call I.V.

Current Hist. Vol.

10/30

30 Days Ago H.V.

10/30

210 68% 38% / 40% 48% / 89%
220 62% 38% / 40% 48% / 89%
230 61% 38% / 40% 48% / 89%

This table tells us that call premiums are implying volatilities as high as 68%, yet current stock volatilities range from only 38% to 40%. The actual volatilities 30 days ago were higher, which indicates that the stock’s actual price volatility had been falling.

These higher-than-actual IV values indicate that the market anticipates higher volatility in the stock, and imminently. This usually is based upon an impending news event. In such cases when IV moves significantly higher than actual volatility, it is known as a spike in implied volatility.

If IV is out-of-line high, might you not want to know why? In fact, ISRG was scheduled to announce its earnings on October 18th, one day before the Oct-2007 options expired, the likely culprit causing the IV spike. The point is that something was driving IV so high. Wall Street does not give away premium, and traders do not bid up option prices without a reason.

The table in Figure 5.14 examines how time affects IV for different option strikes, using Sina.com (SINA) again as our example. When this table was compiled on November 14, 2007, SINA was $49.50 and the current 10-, 20- and 30-day historical volatilities were 90%, 78% and 67%, respectively, which shows that actual volatility was increasing over the last 30 days.

     Figure 5.14

Sina.com – Effect of Time on Implied Volatility

Stock: $49.50

Level of Implied Volatility

Call Strikes Nov-07 Dec-07 Jan-08 Mar-08 June-08 Jan-09 Jan-10
40 – ITM 114% 70% 68% 68% 61% 54% 53%
45 – ITM 140% 71% 68% 67% 61% 54% 50%
50 – ATM 146% 73% 69% 67% 60% 54% 50%
55 – OTM 139% 74% 69% 67% 60% 54% n/a
60 – OTM 144% 75% 68% 67% 60% 55% n/a

 

Note how high IV is for the current-month SINA options: as high as 146%, even though the current 10-day historical volatility is 90%. While stock volatility is quite high, the ATM call’s IV is through the roof. Clearly, the market is expecting something to happen. Implied volatility in the ITM $40 Call is considerably lower, at 114%. The lower IV level is due to the lack of trading activity; the relatively lower demand for the deeply ITM call does not bid up its price.

As we saw in Figure 5.7, which illustrated the effect of time on delta, we see IV also falling as time increases. The greatest fall in IV is for the ATM 50 Call, which had the highest level of IV in the current option month. Suppose that one bought the current-month ATM call (IV of 146%) and an announcement occurred of the event that was causing IV to spike. Even though the stock might not move significantly, the level of IV would fall dramatically, back into line with historical volatility, causing a collapse in the option’s value. This occurrence, known as the volatility trap, devastates the call buyer; this indeed is why option buyers should think twice before buying overpriced options. The further out in time one buys options with high IV, the less they are affected by a collapse in IV.

Suppose we were to sell high IV instead? The collapse of IV is quite favorable for a writer of the calls. Our objective would be to capitalize on its collapse by buying back the option at a price far lower than we sold it for. Selling an option that is multiple months out in time, however, fails to capitalize on the IV collapse, because the IV levels even in the second month are actually far lower than actual volatility; and only decline further with more time to expiration. Selling volatility (which actually means to sell high implied volatility) on Sina.com would only make sense for the current-month calls; they are the only ones that will benefit from a collapse in the high IV because they are the only ones that have high IV.

The following volatility table illustrates how historical volatility can change in the short term, and how the implied volatility for the current month’s ATM call compares to historical volatility. Where IV is reasonably close to (within 15% of) current 30-day volatility, I have considered it to be “in line” with historical volatility. Numbers have been rounded for ease of reading.

Figure 5.15

Volatility Table – S&P 100 Selected Stocks

30-day Historical Stock Volatility
Stock Current One Week Ago One Month

Ago

H.V. Trend Current ATM Call

Implied Volatility

ATI – Allegheny 44% 51% 46% Flat 37%Low
AA – Alcoa 37% 42% 47% Down 42% – In line
MER – Merrill 33% 36% 45% Down 37% – In line
BHI – Baker Hughes 21% 23% 26% Down 28% – Slightly high
EP – El Paso 23% 27% 31% Down 26% – In line
GOOG – Alphabet 15% 18% 23% Down 27%High
DELL – Dell Inc. 28% 28% 27% Flat 25% – In line
CI – Cigna 24% 28% 42% Down 24% – In line
HD – Home Depot 35% 37% 35% Flat 25%Low
BA – Boeing 20% 24% 30% Down 21% – In line
HPQ – HewlettP 24% 26% 30% Down 22% – In line
LEH – Lehman 51% 58% 64% Down 32%Low
ROK – Rockwell 31% 33% 34% Flat 25%Low
GM – GenMtrs 53% 51% 41% Up 40%Low

Note first of all the low volatilities: only LEH and GM had a current volatility above 50%, and the average is 30%. All these stocks offered covered calls with a few weeks remaining to expiration of 3% or better, even though volatility and IV both were low, except in the cases of LEH and GM. Yet at the time this list was produced, the market had been quite volatile for weeks due to the credit crunch, the housing recession and a major market correction that began in late July 2007.

For those who believe that covered call writing is founded upon writing volatile stocks or stocks with sky-high implied volatilities, you can see that just is not necessarily the case. Several of the above plays offered good premium with implied volatility lower than actual volatility. Only two of these trade candidates had IV that was significantly higher than actual volatility, and it wasn’t much higher. This is why I insist that covered call writing is only “conservative” when practiced on excellent companies.

For comparison, let’s look at the top ten covered call trades that appeared the same day below, presented in Figure 5.16:

Figure 5.16

Volatility Table – $10 to $20 Selected Stocks
30-day Historical Stock Volatility
Stock Current One WEEK

Ago

One Month

Ago

H.V. Trend Current ATM Call

Implied Volatility

MDTL – Medis 73% 83% 96% Down 64% – Low
AVCI – Avici Sys. 58% 67% 123% Down 96%Very High
BBW – BuildaBear 58% 59% 53% Flat 75%Very High
HOV – Hovnanian 21% 23% 26% Down 28% – Slightly high
MTH – Mer.Homes 84% 95% 93% Down 80% – In line
INSP – Infospace 87% 92% 65% Up 48%Low
DHI – D R Horton 48% 51% 49% Flat 62% – High
JSDA –JonesSoda 48% 109% 117% Down 61% – High
KGC – KinrossGld 39% 53% 51% Down 42% – In line
ALVR – Alvarion 39% 42% 57% Down 59% – Very High

 

Note how high the actual volatilities were on these companies, compared to the S&P 100; and how high implied volatilities were. I consider a 50% stock volatility to be fairly high, and that actually would be a low volatility for the $10 to $20 list – at least on this particular day. Of course, volatilities will vary by market conditions. The market correction and subprime/housing problems noted above had very different effects on the stocks appearing on this list than on those appearing on the S&P 100 list.

It is worth noting that the returns on the S&P 100 trades were about half that of the trades appearing on the $10 to $20 list. This underlines the return vs. stability trade-off that covered call writing often involves.

In my experience, it is worthwhile to compare the implied volatility to historical, for which I tend to use the 10- and 30-day volatilities. It is helpful to know if IV is high, in line with historical, or even lower. But this is a relativistic measurement; the stock’s volatility level is meaningful in and of itself. The more volatile the stock, the riskier it generally will be for covered call writing.

But you must look at both the 10- and 30-day volatilities to get a true picture of current volatility. If the 10-day number is lower, it means the stock was recently more volatile and volatility is declining. If the 10-day number is higher, volatility is increasing. Therefore for me, the 10-day volatility is the more important number. In measuring whether implied volatility is in-line or not, it seems to correlate best with the 10-day stock volatility, as we would expect.

As a realistic matter, for covered call writing I do not want to see IV significantly higher than either the 10- day or 30-day stock volatilities. This also means that I don’t want to see the 10-day volatility a lot higher than the 30-day, because I don’t want a stock whose actual volatility is recently increasing. Better that it be decreasing instead.

IV is Higher than Historical. If IV is quite high compared to historical volatility, the stock likely is facing an event horizon that is driving IV so high. This is a tip-off that one should look further for a news event, such as an earnings report, that is driving premium up. Or just find another trade, unless your goal is to write the high IV in order to capture the volatility collapse and you have made a reasoned judgment that the stock is not likely to collapse along with the high implied volatility!

IV is In-Line with Historical. If IV is in line with – the same or just slightly higher or lower – than historical volatility, then IV is not “high” in relation to actual volatility, even though stock volatility might itself be high. If IV is within 15% of historical (10-day and 30-day) volatility, I consider it to be in-line. But the fact that IV is in-line with actual volatility is no comfort if volatility is high.

I consider stock volatility over 40% to be high and over 60% quite high, for conservative covered call writing. Keep in mind that the S&P 500’s average volatility is under 15%, historically.

IV is Lower than Historical. Where IV is meaningfully lower than stock volatility, we at least have the comfort of not writing high IV. This does not guarantee that the stock is a safer covered write, however. We must consult the fundamentals and chart to determine this. And if actual volatility is higher, the fact that IV is lower may not be much comfort, since the stock is a volatile one. Keep in mind also that when IV is lower, we are not being paid for actual volatility.

Volatility Level and Trend. Just how volatile is the underlying stock? And is that volatility increasing or decreasing? If it is increasing, why is it doing so? A recent increase in stock volatility from 22% to 27% is not cause for much concern, perhaps. But an increase from 35% to 65% is quite a jump.

It generally is better for unprotected covered call writes (those not put-protected) to avoid high-volatility stocks. This goes double for the smaller and less-established companies, which can undergo extreme price volatility, even when the market or industry is not.

Similarly, an increasing volatility level is worrisome. If the increase is modest, it is not of much concern, but a serious increase should be looked at: something is causing the volatility spike. For example, in the S&P 100 table above (Fig. 5.16), GM shows an increasing level of volatility. However, volatility was on the rise due to imminent talks with the unions about health-care costs. Positive news on that score caused IV to fall, which is likely why it was 40% – much less than the 53% current stock volatility level. In this situation, premium remained good even though IV (and the market’s perception of risk) had diminished.

It can take days and sometimes weeks to effect a meaningful change in stock volatility, but IV can change almost instantly as market makers adjust premiums upward to roll in higher perceived risk, or downward to recognize perceived lessening of risk.

Large-cap companies can evince fairly high levels of volatility and therefore throw off excellent call premium month after month. These companies can make some of the best covered writes.

By comparison, oil-industry company Baker Hughes (BHI) offered great covered call returns, though its historical volatility level averaged less than 25%. While slightly high compared to the S&P 500’s historical overall volatility, it is low for stocks offering good covered call returns. They are there to be found!

Always view historical volatility in conjunction with the chart to get a feeling for the “ground truth” of the volatility number. For example, Home Depot (HD) had a current volatility of 35% as shown in the S&P 100 table above, yet it had fallen from $42 to $32 in three months, affected by the housing decline and mortgage refinancing woes. Just looking at the volatility would not have given a true picture of the stock’s recent price performance, which has been declining.

It is worth saying that many covered call writers (and website operators) disagree with me about attaching any importance to volatility or IV. They eschew any need to look for pending news that might be causing high IV. But as these tables indicate, do you see that out-of-line high levels of IV might merit a little further investigation? Careful writers do not blindly walk into this high-IV buzz-saw.

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