When discussing the markets, there’s a common question among investors and traders: "What’s your position?" The answer often varies based on the individual’s level of expertise.
For beginning investors, the answer is usually “I own a few stocks.” For the intermediate investor or trader, it might be “I have covered call positions or option spreads in several names.” For the advanced or professional trader, the answer might be very different and involve being “long or short volatility.” Here’s why.
Investors typically own stocks and tend to have an upward bias toward the stock market, whatever the size of their positions or portfolios. Traders, on the other hand, seek to generate profits in both directions—up and down. Traders look for opportunities where events have caused things to be temporarily “out of whack.” Traders often look to exploit this divergence from the norm and potentially profit from it. So how do traders do that? Mean reversion.
Mean Reversion of Implied Volatility
Mean reversion is the theory that, over time, something will move back or return to its average historical levels. Put another way, things usually return to normal—eventually. The problem is, stock and option prices are typically not mean reverting. For instance, a stock can go up and keep going up. It doesn’t necessarily have to move back to its average price over a specific time period.
So what do professional traders look at instead? Implied volatility (IV). The IV of options is considered mean reverting, which means that for the most part, it typically rises after it gets too low and falls after it gets too high. Traders can use this ebb and flow to establish and manage positions.
Let’s look at an example using the S&P 500 (SPX). The SPX IV over the past three years (see figure 1) shows a range of about 0.10 (10%) to about 0.29 (29%).
The SPX IV tends to bounce between about 15% and 20% to 25%. To be sure, there are periods of extreme volatility. Just look at the spike in the SPX IV in August 2015 and then again in early 2016. But the ebb and flow of IV usually returns to a long-term average.
Seasonal factors and events—both on the calendar and unexpected—can be factors in implied volatility trends. Spring and summer historically drag down volatility unless events drive it higher.
IV can be measured and monitored to help a trader make strategic decisions for taking long or short volatility positions. For example, when IV is at the low end of its range, an options trader might look to take advantage by buying calendar or diagonal spreads. When IV is at the high end of its range, short vertical spreads and iron condors might be worth considering.
Index of Market Implied Volatility
There’s another way to look at IV for the SPX: via the CBOE Volatility Index (VIX). The VIX just happens to measure implied volatility of the SPX, similar to the SPX IV study in figure 1.
Looking at the three-year chart of VIX (see figure 2), you can see it follows the trajectory of the IV study pretty closely. The spikes tend to be higher in the VIX, but overall, the trends are similar.
The VIX has grown in popularity to the extent that there are now options traded on this volatility measurement. Traders can use VIX as a macroeconomic measurement or trade options on the actual VIX level. Many professional traders use a combination of volatility data and strategy to exploit the mean-reverting aspects of volatility.