Can Option Implied Volatility be a Predictive Measure for Underlying Direction?

I thought I would launch a cruise missile of an idea right at the readers of Expiring Monthly.  At first blush someone would read that title and say, “Yeah, yeah when the VIX is under 20 it is bullish and when the VIX is over 20 it is bearish for stocks in general.”  Surprise, I am not going to talk about the VIX.  But for those wondering the market just rallied 1000 Dow handles and the VIX went from the 40’s to the 30’s in the first 10 days of October.  There goes that theory.  It thought I would use a slightly more sophisticated view of the interplay between 30 Day Historical (Realized) Volatility and 30 Day Implied Volatility (forward looking options) and see if there is an interesting pattern to be had.

First I want to describe the action between HV30, how the underlying has moved, and IV30, how the market is pricing the next 30 days movement.  Options are one of the few instruments that actually try to predict and price future movement.  Want to see what the market has in store for your favorite momentum stock?  Just check out the IV30.  You can back out the daily movement easily enough but you cannot get direction.  That is the tough part and a reason many professional traders limit delta whenever possible.   Under certain conditions there might be something to the difference between HV30 and IV30.

If the HV30 trails the IV30 by a large number, say 10 points or more, the market is predicting a bigger move in the future then recent history.  Standard trading practice (at least how I know it) would say selling options would be the way to go since the decay would destroy any reasonable action to scalp the  curvatures of the position.  Traders call this a Frontspread.  The other side of the coin has IV30 trading at a discount to HV30.  Here you would want to own options to take advantage of the ride since the underlying is moving much more than the options predict.  Traders call this position a Backspread and look to gain from increasing option prices or scalping stock into position curvature.  In general as stocks climb, paper sells call options to lock in gains.  Any trader who has been long options and short stock (Backspread) on a slow melt up will attest to the feeling.  They can describe this viscerally. That is just how the option world works and a reason why the call skew is negative as measured from the At the Money options for most equity and index options.  Volatility Compression is what happens under normal circumstances as names drift upward for most equities.

What happens when the traditional order flow pattern breaks down?  When paper buys options instead of sells them on the grind up?  Look at the figure below and look at the action in HV30/IV30 for the SLV (IShares Silver Trust) prior to the collapse in the price of Silver in early May.  All through the month of April you note that as the SLV climbed higher and higher IV30 stayed on top of HV30 until the relationship inverted right after the SLV crash.  Paper was not selling calls into the SLV upswing; paper was buying calls into the upswing.  Silver mania was gripping the market and the bubble appeared in full swing.  The large spike in HV30 show the subsequent big drop in the SLV with the IV30 imploding as the market direction became clear.  The key here is the launch of HV30 as SLV continued to climb with IV30 racing ahead of it.  Is there another example?

Now let’s examine the pricing action below in the GLD prior to the recent big sellout this fall.  Essentially you see a similar pattern to the SLV.  From early July and gaining steam in August with the increase in HV30 GLD kept IV30 ahead of the underlying movement in a measurable way.  More paper on balance was piling in with the increasing HV30.  That is the key, will buyers with the expanding underlying volatility.  By early September the big sell off in the GLD had happened.   The only thing keeping GLD up really is the Euro Zone crisis or most likely the metal would have seen $1500 per ounce.

Now we have this nifty idea of using two volatility measures to help pick direction.  I will grant you the skew in the commodities is inverted as the call skew is positive but the increasing HV30 on the way up is a warning flag.  By using volatility this way you get to see the character of the move up as not every pop in an underlying will display this.  But I found it interesting that both the big metal plays this year showed very similar circumstances in these two common volatilities measures and it looks like a reasonable way to test highs in the next great momentum stock.  There has been chatter about the Treasury bond bubble so take a look at the same measures I identified above.  Is the TLT really the next great bubble?

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