$SPX and the Volatility Risk Premium

$SPX and the Volatility Risk Premium

 

$SPX and the Volatility Risk Premium is darn high.  I don’t know what percentile the current level of IV is in but it is very expensive relative to how the $SPX is moving.  I don’t know why that is.  At first blush I think for the foreseeable future we should call it the Tweet Risk Premium.  The chances that a random tweet comes out to upset the happy and rolling economic apple cart seems higher than under other Presidents.   First what is a Volatility Risk Premium (VRP) anyway?

VRP is the extra cost of options over the current or realized move of the underlying.  It is why there is money in selling options most of the time.  Liquidity providers can get away with charging more money for options because of the inherent nature of the leverage in an option contract.  You want the go-go juice, you must pay up for it!  As a market maker, one of my better skills was pricing options based on what I thought was the expected movement.  As traders, we want to learn to make that assumption to increase our chances of success.

$SPX chart of by Cboe LivevolPro

For instance, Pres. Trump wants $AAPL to shift production of the iPhone to the USA.  $AAPL tumbles on uncertainty and now there are new expectations in the short term around where $AAPL can go.  I don’t see $AAPL leaving China but that is beside the point.  The premiums went up in $AAPL on the news anyway.  I think short term there are ways to sell that VRP.  That example leads us to the $SPX.  Why is the $SPX trading with a $14 VIX, a proxy for 30 day implied volatility, when $SPX is barely ringing in at 7% volatility over the last 10 days?   The reason is expectations.  Traders think something will happen relatively soon.

Since we just traded 2917 $SPX and are near the top any better news, or conclusion of the Trade Wars, would put $SPX back on the upward swing.  The bigger question is if the market gets “tired” supporting all that extra premium.  Something has to give so either the market moves or the implied volatility drops, but both cannot happen indefinitely.   I think it makes sense to price the move above 2900 and junk disaster below 2850.  The VRP is right, sometimes.

To learn how to quantify and trade volatility and price opportunities, check out our Options Made Easy course, HERE.

Disclosure: positions in $VIX, $SPY/$SPX, $AAPL

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