Is Volatility Cheap?

Daily Options Report reports (hat tip Abnormal Returns) on the relative cheapness of volatility (as currently priced in options):

Bottom line is options have gotten cheap enough to where net selling them looks very risky as you have little cushion for a sudden move. But by the same token, it doesn't mean you go back up the truck and cross your fingers that volatility starts ticking up right........now.

It is true that the VIX (which tracks the daily implied volatility on S&P 500 options) has come down MASSIVELY from Fall highs. In the actual marketplace, realized daily volatility has also snapped back in recent months as seen below.

Daily Options Reports continues...

But cheap does not always mean a buy. At the end of the day, you will need realized volatility in GOOG (or anything) between now and expiration to exceed the implied volatility you paid for the option. In other words, you could catch the absolute low tick in GOOG options volatility and still lose money if GOOG volatility itself remains lower.

True, you could. BUT, you can also catch a higher level of volatility and still make money even if volatility decreases. One recent example, I am fortunate enough to say, happened to me. I purchased a boatload of Out of the Money "OTM" calls on QQQQ (to be more specific September 43's) a few weeks back for a few cents each, which I delta hedged by shorting QQQQ's and later by buying QQQQ puts when QQQQ became difficult to short.

What has happened since then? Well, QQQQ's have run up significantly in price and I've continued to delta hedge, BUT the implied volatility on QQQQ's has actually fallen slightly since that time. Importantly, even with that drop in volatility, the combined positions have done quite well. Why? Because daily volatility does not always reflect exactly what is being captured.

According to Wikipedia, volatility is:

More broadly, volatility refers to the degree of (typically short-term) unpredictable change over time of a certain variable.

Thus, volatility only measure the predictability of short term changes. When you buy an option, you don't care how volatile the underlying security performs around the mean (i.e. lots of small movements unless you want to be abused by transaction fees), but rather you care about short-term, yet significant, moves in absolute terms. As an extreme example, if a security returns 0.5% EVERY day for a month, the volatility over that month is... ZERO. Yet, the security would have moved by more than 10% over a 20 trading day period, which is very volatile for the broader market. Thus, while volatility has declined, the option position has likely paid out BIG time.

This can be seen in the chart below. Rather than the previously shown monthly volatility (as calculated on a daily price change), we show the six month change on a monthly basis. Here, we see that volatility over longer times frames has actually not moved down much at all, but has actually remained at a historically high levels.

And this is the reason why I feel that options (and volatility) continue to be cheap.

Source: Yahoo Finance