Implied volatility and realized volatility don’t normally diverge that widely. They are usually separated by a small amount, maybe 15-20%. Recently, a very large divergence was quite noticeable for options traders.
For those of you new to options trading, let’s define these two types of volatility measures.
What is implied volatility?
Implied volatility (also called historical volatility) measures future market moves that are expected. That could include earnings reports, a merger/acquisition, and other events that can have a bearing on earnings. It tells us how prices will move and the size of those moves.
Remember, stock prices reflect discounted future cash flows. The further out you go, the more speculative the measurement is and the higher the potential to be wrong (in terms of price and time).
What is realized volatility?
Realized volatility is the actual move in stock volatility. It is often different than what is implied, but the variance is not often wide. (As I said above, it’s typically in the 15-20% range.)
Why is this important to us as traders? Well, if you trade options, then you understand prices are set based on implied moves. Prices are derived from historical movements and averages to understand how far a stock might move following an event or simply with the market.
The recent divergence
In late April and into early May, we had a very large discrepancy between realized volatility and implied volatility that stood out for option players.
Realized volatility was exploding, which means stock prices and indices had experienced very large moves up and down. These moves were not expected due to low or declining implied volatility. Hence, option prices were not moving as expected; rather it felt like being in the spin cycle of a washing machine. Stocks were moving sharply but options (puts and calls) were not priced for it.
It was a rare condition that was soon rectified and is now back to a “normal” variance. Still, those violent swings surprised most traders.
Here is what my friend and colleague, Larry McMillan, author and founder of Option Strategist, said about this recent divergence:
There have been only a few times in history when HV20 rises enough to get 10 points above $VIX. Some of those occasions, though, have lasted for quite a while, and sometimes the market can fall precipitously while this condition exists. I liken it to an oversold condition for the stock market: eventually the market will rally, but you probably want to exercise extreme caution when HV20 is more than 10 points higher than $VIX.
(HV20 refers to historical volatility based on the 20 previous trading days.)
How to trade when implied volatility and realized volatility diverge
Though this is a rare occurrence, it does happen. You can either reduce your risk (sell and sit on the sidelines while holding higher cash levels) or play both sides simultaneously, which is called a strangle or straddle. Buying at-the-money or slightly out-of-the-money puts and calls (with the same same expiration) allows you to play for lower realized volatility or higher implied volatility as you wait for a bigger move to happen.
