This is Part I of a discussion of VRP

The volatility risk premium (VRP) is the notion that options are generally overpriced. Not all the time, not in every name, not across the entire surface. Just in general.

What to do with this information is another matter.

If their premiums are higher than their cost to replicate you can sell them, hedge, and earn a profit. If the expected value of owning an option is negative you can still buy them to make an existing portfolio safer. The combination can be a better proposition than looking at any of the line items in isolation.

Either way, we want to separate price from value.

In Primer #8: Top of the Funnel: Cross-Sectional Fair Value, I define how moontower.ai computes VRP but we’ll use a slightly simpler computation for this post:

VRP = 1-month implied vol (IV) / 1-month realized volatility

• The implied volatility is “constant maturity”. This means we interpolate between the 2 closest expiries which surround 30 calendar days into the future. The interpolation is linear in log(time). Or you can linearly interpolate variance (ie volatility squared) and convert back to volatility. Same thing.
• The 1-month realized vol for this post is simply the sample standard deviation of the last 20 daily logreturns annualized by √251

If implied volatility is 20% and the realized volatility is 15% then the VRP is 20% / 15% or 1.33.

In the moontower tools we’d refer to this as 33% or VRP – 1 to represent it as premium/discount.

If the implied vol was only 14% then the VRP is 14%/15% – 1 = -6.7%

Forward-looking vs backward looking

Implied volatility is set by market consensus. It’s the number that makes an option model spit out the price for calls and puts that actually trade. It’s both forward and backward looking.

It’s backward-looking because traders use history to handicap what volatility can be. SPY and TSLA behave differently. You’d love to buy TSLA options for SPY implieds and sell SPY options at TSLA implieds. In fact you’d pay for the privilege. So would everyone else. Your bid price to this is a pairwise microcosm of how the options surfaces in the world arrange themselves in a giant, relative matrix. Much of that matrix is pulling from how these assets move and co-move. That’s historical info.

Right now, is a great example of how option markets are also forward-looking. With the US elections approaching, there is an outsize chunk of 1-day variance waving to us from nearly every option term structure. This is TLT with the maturity dominated by the election highlighted:

This volatility is less driven by the past moves. a projection of past moves is blended with an estimate of how much bonds might move on election day.

💡See Understanding Implied Forwards to learn more about the blending.

This highlights the tension of VRP ratios. The numerator knows things the denominator doesn’t.

From the Primer:

The VRP ratio divides IV, a forward-looking measure, by a lagging realized volatility. We understand both the embedded utility of such a measure —vol clusters, so recent volatility is correlated to the expected future volatility; and the tension that the numerator anticipates the future while the denominator reports the past. But there is a wrinkle around known events that distort our interpretation of the measure. The following examples characterize the distortion:

1) Upcoming earnings or FOMC day

Implied volatility will anticipate the extra variance associated with the upcoming event, artificially widening the VRP. Professional option traders will use quantitative methods to extract how much extra variance the market is assigning to the event to “clean” the IV. Ideally, VRPs would be adjusted for known events. There is no single accepted technique for cleaning the IV but the quick solution is a judgment — “XYZ has an abnormally high VRP, but I just noticed it has earnings next Tuesday”. [The moontower.ai roadmap includes providing a calculator to allow a user to extract an event. In the meantime, you can use term structure tools (described later) to “see” where the market anticipates events]

2) Earnings have recently been reported

This is the opposite failure mode of the VRP measure. A stock had a large earnings move which carries significant weight in the realized volatility (the denominator of VRP) but the IV is looking forward to a period where there is no news expected since the company has already given guidance, had a conference call, and reported financials. This will artificially depress the VRP. Again, judgment is in order. It’s best to compare the IV to periods of realized vol without the earnings move.

Quants have spent many a brain cell trying to forecast volatility. For good reason. If your forecast is better than the one embedded in the implied, you could Doordash Sizzler like a boss.

In the moontower.ai tools we can see how well the implieds predict the realized vol.

This is double-paned chart is XBI 30d IV vs 30d realized vol. The top panel shows how the implied vol is usually a bit rich to the realized but not always.

In the bottom panel, we toggle “Lag IV”.

This lags the implied vol so we can see how IV tracked the ensuing realized vol. You are looking at the realized vol next to what the implied vol was a month ago (hence the “lag”).

The red box on the chart is August 5th. The realized vol naturally shot well over the IV from a month earlier (in other words, if you bought XBI options in in July they were cheap compared to the movement August 5th had in store). In addition, the top panel shows how IV itself also shot up on August 5th. But as you look back at the bottom panel, you can see how that elevated vol turned out to be much higher than the realized vol that unfolded the remainder of August as the stress seemed to depart as quickly as it showed up.

For the rest of today we will examine data from the past year to get a feel for the VRP in lots of tickers. VRP is a popular topic in options, you’ll want to understand its shape.

It’s the option market’s point spread.

Setup

I looked at closing data for the past year (10/11/23 to 10/16/24) to fetch 30d IVs and 20d close-to-close realized vols for each trade date.

📅There are about 21 trading days in a 30d calendar month so the time windows are lined up well enough.

Table

The table shows the average VRP (as well as the standard deviation of the VRP) and the average lagged VRP which tells us the average premium/discount the implied vol had to the ensuing realized vol. To a sports bettor, this is like asking “how did the realized vol do against the spread?”

Observations:

• SPY, on average had implied vols 9% premium to 1-month realized (ie if 1-month realized was 10% the implied was 10.9%)
• There is a positive VRP in most names.
• The single stock names at the bottom of the table were underpriced volatility on average. A glancing thought — vol traders have noted (lamented?) extremely low levels of implied and realized index correlations for the past couple years with index volatility trading historically low compared to single stocks. This high-level snapshot shows the single-stock vols are not even absolutely expensive.
• Many of the foreign vols were much higher than the realized. HYG is always expensive but trades at an absolute low level of volatility. One thing to appreciate about volatility is that standard deviation is only one varietal of risk. In the presence of skew, focusing on standard deviation is misleading. The standard deviation of a balanced coin flip is 66% higher than a biased 90/10 coin flip. But would you conclude the balanced coin is riskier? See 🤡Skew Is A Hall of Mirrors
• Finally, note how well the average lagged VRP affirms the average VRP. If you average across all these names for the past year both the VRP and the lagged VRP (ie how the IV did compared to the ensuing realized) stood at an 8% premium to prior and eventual realized vols! The names below the slope =1 line have on average outrealized their implied vol.

   

Crossing a 4-ft deep river

You know how this story goes. If you want to cross a river, it’s not enough to know how deep it is on average.

So far all we’ve done is look at averages.

Looking at all the tickers zoomed out, the average VRP by name reflects how expensive the options are compared to the realized even on a going-forward basis. It’s a buzzkill.

Until we look under the hood.

Let’s open up SPY.

The x-axis is the VRP while the y-axis is the VRP that end up being realized over the next month. This is not well-behaved. There are times when the VRP is

• The upper left quadrant = “low VRP but realized ended up underperforming”
• The lower left quadrant = “low VRP and realized outperformed the low already discounted IV”
• The upper right = “these were good sales — vol that screened high and realized couldn’t catch up”
• Lower right = “vol was high and turned out not to be high enough”

We can zoom a bit further by halves.

When VRP is negative…and VERY negative:

When VRP is positive…and VERY positive:

And finally, the time series which shows how the serene surface behavior of averages is really a river of many depths:

• We see that when the VRP dips, it’s often the case that the realized VRP (red line) spikes meaning that the low VRP wasn’t low enough! Selling low VRP can absolutely payoff. The reason I added the IV line in there is because, low VRPs are often coincident with high volatility. Why? Because the market expects mean reversion back to more normal levels of volatility. What surprised me about this chart is how low VRPs even at low IVs failed to reward the option longs.
• You can again see Aug 5th — when the red line or realized VRP goes sharply negative it shows how the realized vol was much higher than anything July anticipated. You can also see the VRP (blue line) collapse shortly after the stress as the options market discounted the previous elevated RV and looked ahead to more normal times.
• A general caution — you cannot tell from this char whether the high or low VRPs are being driven by the numerator or denominator. (This is why the first 2 filters in the moontower.ai funnel are the Dashboard and Real tools explained in the Primer — a glance at both of those charts and you know what’s fueling the ratio.)

   

Let’s do one more. GLD.

I’ll narrate the numbered sections:

1. IV is elevated but realized vol must be high since the VRP stayed muted. The options ended up being highly overpriced as the spiked red line indicated the realized VRP approached 60%! We can see that the IV cratered from about 16% to 11% from Oct to Nov 2023. Considering how the VRP (blue line) rose during that period we can infer that the realized utterly collapsed.
2. When the vols got under 12% they were a huge bargain. The lagged VRP showed the vols being much cheaper than the ensuing realized.
3. Once again, IV popped higher, VRP didn’t follow, in fact the options were trading at a large discount to RV — and correctly so it turns out. The lagged VRP was brutal for the longs.
4. The lowest lagged VRP got all year corresponded to vols and VRP getting cheap. The obvious trade paid off.
5. Another relatively obvious one pays off — IV and VRP spike and sure enough those vols couldn’t support the ensuing realized.
6. This was yet another obvious one that paid — the one I wrote up in Flash post on GLD vol and Options Are ALWAYS About Vol. Vol roofed, VRP popped and the ensuing realized massively underperformed.

Closing thoughts and what’s next

Option markets are games not problem sets. You don’t solve them.

There’s no single killer metric. You are constantly triangulating against everyone else whose is also triangulating. You can’t look at VRP in isolation.

• What’s driving the numerator vs denominator?
• What’s the distribution of the variable in the numerator vs the denominator?
• How do other tickers compare using the same sets of lenses?

While none of the math here is beyond 6th grade, this is a lot of mental shape rotation. It’s cognitively demanding every time you hear or read “VRP” or “lagged VRP” if you have to translate in your head “high VRP means IV is high compared to…blah blah”.

Just like learning requires looking away from the page and re-stating what you’ve studied in your own words, you need to practice. Look at option chains and vols, try to come up with trades and talk yourself out of them. What you can’t talk yourself out of becomes a candidate.

If you’re already reading this far you’re paying for the substack — sign up for moontower.ai, you get the substack for free, and you can practice every day with the tools. (I say it and I mean it — the cost of the software rounds to zero if you actually trade. The true cost is the practice of getting better.)

[Btw, if you are a professional whether a broker, trader, writer, investor this lens will tell you quite a bit about what the options market thinks about a name which is useful for taking risk or providing unique context to clients, readers or stakeholders who are trying to pull signal from noise.]

A word on data hacking

• I used overlapping data since I’m looking at rolling 20-day windows every day over the past year. This “shrinks” the sample size tremendously. It’s ok for this context since we aren’t drawing conclusions or trying to estimate frequencies. The point of this post is to give you the shape of VRPs and to inspire your own explorations by giving you some angles you may not have considered.
• In the time series chart, I’m narrating from left-to-right. But when I say the IV is high or low, presumably versus the “mean IV” green lines, I’m cheating. The mean IV is based on the 1 year history of IV that we studied but if it’s March 2024, my definition of “high” or “low” vol will depend on prior data only. The green line is “snooping” into the future if you read from left-to-right. One could correct for this by keeping track of what percentile or z-score the IV is in compared to its prior history (we use percentiles in multiple contexts in moontower.ai — they are suitable for identifying unusual values).

Next…

In next week’s follow-up we go bit deeper to appreciate how you can manipulate the inputs into VRPs to identify potential vol trades. I said VRP is the option market’s point spread.

Except for a tiny wrinkle.

There’s no single line.

Back on Oct 17th, I sold Z24 WTI (oil) 67 strike puts unhedged.

I explained my reasoning in this thread back when I did the trade. They were the equivalent to the USO Nov 15th 69 puts (I said Nov 22nd expiry but that was in error.)

I covered the WTI puts on Thursday morning. I published this thread when I covered them. Here’s a mildly edited version:

We’ll use the USO puts to write the post-mortem of a roughly 2 week trade. I hope its super educational.

Let’s start with the vibes.

Markets feel a bit, I don’t know, ahead of themselves. Everything but oil popping (til today). Rates & USD higher.

I’m less bullish on oil (and broadly bearish).

I cut oil length and bot t-bills this am.

Let’s get to the specifics of the “cutting length” trade because there’s many ways to do that. But my directional bias coincided with wanting to buy back my short vol (the moontower mantra — don’t touch the options without a vol lens).

Why?

Vol has sufficiently relaxed in oil since i sold the puts. The put skew was at normal levels when i first sold the 30d delta puts but the vol was high. Since spot/vol corr was positive that made them seem extra high!

• Today there almost no skew in those (now) .29d puts
• The implied vol is below realized (granted realized is on the high end of the range)
• AND the election is getting negligible vol premium in oil

These pics show the negative VRP and negligible event premium assuming 35% fair base vol (which comes from eyeballing the USO vol term structure).

While that explains the how and why of covering the position, let’s understand the p/l attribution of the position while I held it. We do this with the same type of charts I’ve been showing post-mortems with.

I’ll narrate where your eyes should go so it’s easier to learn.

If the puts were hedged the trade was steadily profitable except for 2 days out of 11 when the market popped.

See the yellow boxes on the red line:

Every day we can see the contribution to the hedged p/l from 2 components:

1. realized vol p/l (tug of war between gamma & theta)
2. vega p/l (change in IV)

The yellow boxes are examples of the daily decomposition.

Look what happened on Friday 10/25’s big down move…the hedged p/l was still positive. Yes, you got hammered on the realized p/l but vol got slammed! The put skew was in fact unjustified. The down move was what I call stabilizing to the market

Down moves aren’t normally stabilizing but my idea was that the Middle East conflict was driving the high vol so in this context a down move would be stabilizing so the total vol was unjustified if oil is lower.

(Ofc I was naked short the puts so that Friday was still a tough p/l day because i experienced a rough delta p/l but overall it was buffered by the puts underperforming)

Over the life of the trade, on a delta hedged basis you would earn $.45 being short the option from $1.76 On an unhedged basis it was $.78 (I actually made more than that because I actually sold the options closer to $2 bc the stock was about the same place it is right now, $71.85)

More importantly let’s look at the cumulative p/l attribution:

Almost all of it came from vega. The option was well-priced from a realized vol point of view!

This all ties in to my general gestalt of “short where she lands, long where she ain’t” bit. If vol is going to relax when it “gets there” then you don’t wanna use the option to bet it’s gonna get there. And if everyone thinks it’s “not going there” then when it does it will destabilize and you’ll wish you owned that option.

As a junior trader I remember selling calls bc “it’ll never get there”. I promise you there are many people who think like that. They don’t understand vol trading.

[An aside: That statement sounds more incendiary than I’d like. It troubles me I can’t fully articulate it. It’s a bit of an ink blot test. It’s understandable if you find that unsatisfying but the raw reality is indifferent to both of our dissatisfaction. In truth, there was a point of separation somewhere along the evolution of trading careers where as things got more competitive from the floor days to today, the traders who were copycatting disappeared into other parts of the business. When trading morphed from time/place advantage edge to positional edge it exposed the copycats lack of deep options understanding. Before Hollywood, there was a “me too” era on option pits across the land, where you only had to be savvy enough to identify who was smart and just make sure you yelled “buy’em” at the same time.

There are a lot of people who sound like they get vol trading. In fact I can’t fully imagine how hard it is for someone who’s not super experienced to tell the difference. The problem with codifying a “trading Turing test” is the same one interviewers have with candidates — as professional-grade info gets disseminated it’s hard to know if someone has earned it or parroted it.]

One of the savviest oil options traders I ever knew had a good formulation:

He’d buy those nominally cheap (but vol expensive) weeny puts when he was bullish. Because if the market dropped he just wanted to own what I call “the trap door” to protect what he really wanted to do…get balls long

In my own trading, i wanted to own the trap door. Whatever everyone thinks is impossible is the option i want. Stick’em in my back pocket and if it ever comes into play I’m the only one with 2 hands on the wheel

I admit this instinct was much stronger when i was trading a big book and i don’t have it as much now (that’s another discussion altogether).

Anyway, I hope this was overall educational. There’s an art to this game called options. If anything i maybe it gets the ole mind bicycle spinnin’ in such a way that even if you don’t trade options, it can mentally upgrade your whole investment decision OS.

Markku Kurtti is an engineer in the telecom world. His outsider quant take on portfolio construction is beautifully derived and intuitive.

I strongly recommend his interview with Corey Hoffstein:

🎙️Diversification is a Negatively Priced Lunch (Flirting with Models podcast)

His blog is also outstanding. I’ll point you to this post in particular:

How much skill a concentrated stock picker needs to beat a diversified benchmark? (17 min read)

I summarize key findings below (with the aid of an LLM). The “Moontower highlights” are direct quotes from my kindle.

The central theme:

For a stock picker to successfully manage a concentrated portfolio, they must generate sufficient alpha to overcome the inherent risks and volatility associated with fewer holdings.

Supporting points:

1) The Balance Between Concentration and Diversification

Concentrated portfolios inherently carry more risk due to idiosyncratic variance, or the unique risks associated with individual stocks. To overcome this risk, stock pickers need to generate enough alpha to offset the “variance drag” — the reduction in expected growth rate caused by high volatility.

🟡Moontower highlight: “Portfolio construction of a skilled stock picker is a compromise between enhancing alpha by concentration and mitigating idiosyncratic variance drag by diversification.”

2) Importance of Consistent Skill and Alpha Requirements by Stock Size:

Different types of stocks require varying levels of alpha to beat the benchmark. Larger, more stable stocks typically require less alpha than smaller, more volatile stocks. Consistency in skill is crucial, as erratic performance increases the minimum alpha required to compensate for the higher risk.

🟡Moontower highlight: “Assuming perfectly consistent stock picking skill over time, 10-stock big stocks portfolio has historically required roughly 0.5 percentage point (pp) annualized alpha, small stocks ~1pp and micro-caps ~2pp. High E/P, E/B, Mom and B/P styles, in the universe of all stocks, have required roughly ~1pp and low E/P, E/B, Mom and B/P styles north of ~2pp. Low E/P style (smallish growth stocks with low profitability) have required the highest 2.55pp alpha.”

3) Risk of Concentration Without Skill

Concentration magnifies returns but also heightens risks. Without genuine stock-picking skill, a concentrated portfolio becomes increasingly likely to underperform over time. The document cautions against relying too heavily on concentration to boost returns without sufficient alpha.

🟡Moontower highlight: “But concentration is risky. If you concentrate and don’t have genuine stock picking skill, time will be your enemy.”

4) Circle of Competence and Style Diversification

The post emphasizes the value of investing within one’s “circle of competence” — areas where the investor has the most knowledge or advantage. However, it also warns that focusing exclusively on a single style exposes investors to style risk.

5) Predictability of Variance Drag Over Return

Idiosyncratic variance drag, the penalty for concentrating in fewer stocks, is more predictable than expected returns.

🟡Moontower highlight: “Idiosyncratic variance drag differences are easier to predict than expected return differences. It is therefore safer to increase diversification, which reliably decreases minimum alpha requirement, than to increase portfolio concentration to enhance uncertain alpha.”

🟡Moontower reference: The idea that volatility is more predictable than returns is a foundational principle in portfolio management. See Know Nothing Sizing

6) Lottery Preference in High Variance Styles

Some investors are attracted to high-idiosyncratic-variance stocks with potential for lottery-like returns leading to lower forward-looking returns.

🟡Moontower highlight: “Some investors may prefer stocks that may pay off big and this is exactly what idiosyncratic variance delivers: large dispersion of returns among individual stocks.”

🟡Moontower reference: See A Recipe For Overpaying for a succinct explanation by Chris Schindler.

7) Takeaway on Diversification for Risk Management: Diversification not only reduces variance drag but also lessens reliance on unpredictable alpha.

🟡Moontower highlight: “Our take away is that idiosyncratic variance drag is much more predictable than expected return. More generally, it is easier to predict variance than mean return. It is therefore safer to diversify more as it will reliably bring down idiosyncratic variance drag compared to concentrating more in a hope of higher alpha.”

 

It’s a love letter to diversification mixing words and math. For what it’s worth, at SIG Jeff Yass also called diversification a free lunch.

I’m partial to my Sun/Rain example in You Don’t See The Whole Picture which is an even stronger statement — you are incinerating money by not diversifying but if you evaluate yourself by “resulting” you won’t see it. That’s because the highest bid for risk is the most efficient at absorbing it. This is deeply true in the derivatives world. In the broader investment landscape it’s confounded by info asymmetry, principal-agent conflict, and the comfort of (perceived) safety in herding.

If you want to get deeper into this idea see the back half of the moontower guide:

🟰Understanding Risk-Neutral Probability (link)

 

But be aware…”diversification always means having to say you’re sorry” since something is always losing.

And sometimes almost everything loses. This was Wednesday. Eww.

 

In part 1 of Volatility term structure from multiple angles we opened by discussing how nearer dated implied vols move around more than deferred implieds. Recognizing that dynamic, our net vega position for a time spread can be ambiguous.

Just as stock traders use beta to normalize risk to a benchmark such as SPX, volatility traders will normalize their vega to a fulcrum month. √t scaling corresponds to a model world where time spreads between months remain relatively stable. It’s not reality but it’s a vast improvement over summing raw vegas.

In comparing vols between 2 months, vol ratios are popular. If M1 is 18% vol and M6 is 20%, the vol ratio is 90%. It’s a measure of how steep the term structure is. If you track the ratio for constant maturities then you can get a quick sense of the relative supply/demand for IV. If the ratio is less than 1.0, the term structure is ascending, a shape typical of “it’s quiet now, but we expect mean reversion to typical higher levels of vol”. A downward sloping vol curve is more closely associated with high vol periods or the market’s anticipation of an even such as earnings or the election.

Vol ratios are only one way to measure the slope of the term structure. We saw that implied forward vols are a complementary measure that also describes the relationship between 2 volatilities on the term structure. The computation tells what volatility is baked into the period between the 2 expirations. The logic is that the deferred expiration accounts for all the volatility from now until the option’s last trading date while the near-dated expiry isolates the early period’s expiration. If you consider an extreme example where the time spread is worth 0, ie the deferred option and the nearer-dated option are the same price, the forward vol is zero.

So why look at 2 measures, vol ratio and implied forward vol, if they both tell us about the relative price of implied vol on the term structure?

Remember, we were looking at GLD 1m/6M vols for the 1-year range 10/2/23-9/23/24:

We saw:

The forward vol is sometimes high and sometimes low regardless of the ratio!

But look at early March — not only was the vol ratio low, the forward got crushed. If you only look at vol ratio, you missed this.

Implied forwards are an orthogonal or complementary measure of relative volatility that is additive to your perspective.

Today, we will dive further into the relationship between vol scaling, forward vols, ratios. We will come out on the other side with what this all means for finding trades and managing risk.

Off we go…

Constant Straddle Spread vs Forward Vol

Suppose you are long a time spread.

We’ll say a straddle spread because that’s a common trade expression and it also connotes delta-neutrality.

[It’s probably helpful in thinking about these things to not have to process “call”, “put”, and their associated directionality. Depending on where you are in your learning I’m trying to be mindful of cognitive load.]

You’re long a 6-month straddle for 15% vol and short the 1-month straddle at 15% vol. Front month vol suddenly spikes a point to 16% and the 6-month vol increases by 1/√t (ie 1/√6) or .41 vol points to 15.41%

Here’s what we know:

• The term structure went from flat to descending.
• You lost 1 vol point on your 1-month straddle, gained .41 on your 6-month straddle. Because the 6-month straddle has 2.45x as much vega, you broke even.
• The straddle spread is unchanged.

What happened to the forward vol?

You can compute it yourself with the moontower calculator but I’ll just tell you…the implied forward vol increased to 15.3%

Let’s summarize what happened:

• You are long raw “click” vega since you own the longer-dated option
• You are flat weighted or scaled vega if we use √t scaling with reference to M1
• Vol across the curve increased in proportion to √t weights leaving the straddle spread unchanged
• The forward vol you are long increased, although your p/l is unchanged.

The key point to appreciate:

A constant straddle spread price does NOT mean the forward vols are also constant.

Another way to say this:

The same straddle spread price can yield different implied forwards!

 

Implied Forward Vol: a “many-to-one” relationship

For any implied forward vol there are many pairs of vols that can produce it. This is why the straddle spread and forward are not overlapping measures of term structure.

The table shows:

• many combinations of vols that generate a 15% forward
• √t or constant straddle spread scaling means the forward is changing
• The scaling would need to be sub √t (ie more muted) for the forward to not change. If fact, in a vol increase scenario, the straddle spread price would need to narrow for the forward to be unchanged.

Observing GLD vol data for the past year we can see the many-to-one relationship between:

a) vol ratio and forward vol

For any given vol ratio there are many forward vols. It’s not a function.

b) vol pairs and forward vol

For any given forward vol, the 6M vol can be a fairly tight range while the 1M vol could be far above or below the 6M vol!

You can see how the forward vol and the 6M vol are positively correlated. This makes sense — the forward vol is driven by 5 out of the 6 months in the tenor.

You can also see that at low (high) 6M vols the 1M vol tends to be even lower (higher).

 

Linking the scaling relationship to vol of vol

Remember that weighting our vega by month is analogous to beta weighting a stock portfolio. Beta weighting summarizes a portfolios market exposure with respect to SPX or some other benchmark. Looking at raw unweighted vega is like ignoring the relative volatilities between stocks in a traditional portfolio. $1mm of risk in SPY is not the same as $1mm of NVDA.

√t weighting is therefore suggesting a vol of vol with respect to the fulcrum month (in our examples M1). If the back month vol is more volatile than √t suggests than our long straddle spread is long raw click vega AND weighted vega. If M1 vol increases by 1 point and M6 increases by .75 points, than the straddle spread and forward are expanding quickly. The beta of the back month vol to the front is high.

We can regress GLD 6M vol vs 1M vol to see the sensitivity. Remember a sensitivity of .41 would be √t or constant straddle spread scaling.

√t scaling seems to underestimate the beta of 6M vol to 1M vol. A long straddle spread would be long weighted vega not just raw vega.

We can also compute the standard deviation of vol changes to see the vol of vol. You can see that the empirical 6m vol of vol is less than 1M vol of vol (totally expected) but it’s higher than what √t predicts.

If you truly wanted to be flat weighted vega you’d need to ratio the spread to have less units of the deferred straddle.

 

Takeaways and Discussion

Vol ratios are common ways to represent the steepness of a term structure.

A tradeable expression of a vol ratio is the price of a vega-neutral straddle spread (using our example from today, if you buy 1 6M straddle and sell 2.45 1M straddles). Its performance mimics the vol ratio chart at the beginning of the post!

Ratios just like beta-weighting sterilizes a position from the price level to isolate the slope.

You can even track or trade straddle butterflies to bet on the curvature of the term structure.

These are popular ideas from the futures and yield curve worlds:

From that picture you can see how you might not have a strong opinion on A vs C (a slope bet that would be expressed in a ratio trade) but on the curvature between A and C (which would be expressed via butterfly or a “spread of spreads”).

The forward vol is an orthogonal measure

Implied forward vol changes even if the straddle spread doesn’t. We saw the many-to-one relationship between forward vol and the pairs they come from as well as the vol ratio.

💡Aside on Pairs trading💡

We’ve been talking about vol ratios along the term structure but we can combine our use of forward implied vols to inter-asset or pair trades.

In moontower.ai we have this vol ratio tool. Here USO vol looks rich compared to XLE

But you could also compare forward vol to forward vol difference in a matrix view.

These are cobbled together from 2 screenshots but you can imagine a UI which shows a matrix of all the individual forwards. Those implied forward ratios could then be compared to a vol cone of realized vol ratios between XLE and USO.

 

The orthogonal nature of implied forwards gives you another set of data to run through all your conventional views to see if something stands out.

I’ve mentioned many times in my writing how I hate vol trades that start with “skew is cheap or expensive”. My experience is that the “skew knows”. It’s highly self-fulfilling. Plus implied skew doesn’t vary as widely as realized skew, so you’re forcing convergence trades on a compressed implied range that doesn’t compensate for how sloppy vol can get on destabilizing moves.

Term structure trades on the other hand. This is the place to look.

Risk limits

Deferred vols are less volatile than near dated vols. It’s important to re-scale the vega per month. √t is as sensible choice as any but your survival shouldn’t depend on any particular choice mattering that much since it will be wrong.

Just as you would never trust all of your delta risk management to the concept of beta, vol scaling weights should be taken with a grain of salt both in terms of modeling changes in term structure and in determining risk limits.

As a risk manager, if you constrain net vega without also constraining gross vega (ie the absolute value of vega within each expiry) you are inviting a situation where a book looks flat based on some weights but masks giant time spreads underneath the surface.

Examining vol of vol directly as well as placing term structures into context with vol cones can offer an ensemble view to understanding how extreme time spreads can get.

 

💡A word on measuring vol of vol💡

In this post, I computed the standard deviation of vol changes. Any experienced trader knows that this is incomplete. Because of spot-vol correlation and skew, vol changes are not pure. They are a mixture of moving along the curve vs the curve shifting.

Always ask yourself — “what measure correlates to how my p/l performs?”. That’s what you care about.

In this case, you want to measure the vol of strike vol not some nebulous concept of floating ATM vol.

 

Extending the analysis

Gold doesn’t typically see much event vol priced into it. Some macro reports like unemployment or key Fed meetings will get their bump in the term structure but it’s not the same degree as say earnings for a single stock or the annual USDA Prospective Planting report in ags like corn and soybeans. These sort of events can can 1 or 2 weeks of vol priced into a single day.

Event variance propagates through the term structure in inverse proportion to the DTE. To say it in friendlier terms…they don’t impact the deferred months much relative to the fronts.

I will re-run all these charts for another name (thinking NVDA) for the past year and see what I come up with. I expect a lower vol beta than we saw in GLD but mostly as an artifact of the near-dated vols having a much wider range because of earnings.

I saw a familiar type of riddle on Twitter that was directed at fundamental PMs. I gave a lazy answer and later improved it with a better answer after my half-assed-ness gnawed enough at me.

I’ll reprint the riddle and the better answer here but spelling out the steps in greater detail than I did on twitter.

Question:

Estimate the price of a $180 call (20% OTM) on a $150 stock with 50% volatility, 3 months to expiry

150 Call Calculation (The ATM option)

We start by estimating the at-the-money (ATM) call value using:

ATM straddle = .8 * stock price * implied vol * √(Time to expiry in years)

ATM Call = .4 * stock price * implied vol * √(Time to expiry in years)

ATM Call = 0.4× $150 × 50% ×√1/4= $15

180 Call Calculation (The OTM option)

The 150/180 call spread links the 150 call to the 180 call.

Call Spread Value Breakdown

The call spread’s total probability of expiring ITM is around 45%. This is another estimate off the top of my head.

Although you’d expect 50%, option models assume lognormal stock distributions because returns are compounded. Compounded or geometric returns are subject to “volatility drain”— pulling median price expectations lower than the forward price.

You can think of the expected value of the $150/$180 call spread in two parts:

1. The probability that it expires worth its maximum value of $30. This is P(S>$180)
2. The value on average when the stock expires between $150 and $180.

   This is 45% – P(S>180)

Computing P(S>180)

Note that the straddle is simply 80% of a standard deviation.

The $180 call is conveniently $30 OTM or .80 standard deviations OTM

We know that 1 standard dev encompasses 68% of a distribution, so at a z-score of +1.0 the one-tailed CDF must be 16%

Spelling that out: 100% – 68% = 32% but we only care about the “up” case when the call is ITM, so we cut that in half to 16%.

Since this exercise is supposed to be all mental math, I’ll guess that a Z-score of 0.80 gives a one-tail CDF of ~ 20%, meaning there’s a 20% chance this call will expire in the money (ITM).

We will assume the 180 strike has P(ITM) = 20%

Expected Value Calculation for the 150/180 call spread

1. The case where stock > 180

   E(call spread | S>180) = Max value x P(S>180) = $30 x 20% = $6

2. Case where S is between $150 and $180

   E(call spread | 150<S<180) = Average value of the call spread when s is between the strikes x P(stock between 150 and 180) =

   $15 x 25% = $3.75

   💡Why $15?

   The average roll of a die is 3.5

   The average roll of a die given that the roll is greater than ‘3’ is 5. This assumes a uniform distribution over that range.

   This same style of approximation works well enough for the call spread. Assuming the stock expires between 150 and 180, the call spread is worth $15 on average. The probability it expires between those strikes is the total probability of the stock expiring higher than $150 which I estimated earlier as 45% minus the probability of it roofing above $180 which we estimate at 20%. So the probability of the stock being between 150 and 180 is about 25%

   Hence, $15 x 25%

We sum all scenarios where the call spread expires ITM (ie when the stock is above $150):

Call spread estimate: $6 + $3.75 = $9.75

If the 150 call is worth $15 and the 150/180 call spread is worth $9.75, then the 180 call is worth $5.25

Recapping key bits:

1. Knowing the ATM straddle approximation .8SV√T
2. Guessing that the probability of a >.8 standard deviations ~ 20%
3. Estimating that the probability of the stock going up is less than 50% in a Black Scholes price process (and that at 50% vol that probability is lower than say at 16% vol — in fact the drag is proportional to vol squared)

In the twitter discussion, a great link from 2012 emerged:

Calculating option prices in your head (7 min read)

The Hardy Decomposition offers a handy way to estimate OTM option prices in your head. By breaking down an option’s price into intrinsic value and a HardyFactor (which depends on how far you are from the strike, measured in standard deviations), you can quickly approximate the time value of the option.

The following comes from the post:

Option Price = Intrinsic + ATMPrice*HardyFactor

The HardyFactor is:

d1 is just how many standard deviations you are from the strike.

 

⚠️Looking at a quant forum it looks like the HardyFactor approximation is for options being priced with the ‘normal’ distribution version of the B-S model as opposed to the more commonly used lognormal version

 

Revisiting the riddle

If we revisit the riddle, we know the 180-strike has a d1 = .8 standard devs

If we linear interpolate between .5 and 1 we get a HardyFactor = 40%

Option Price = Intrinsic + ATMPrice*HardyFactor

180 call = 0 + $15 * 40% = $6

My call spread method yielded $5.25

The HardyFactor method (quickly) got us to $6.00

Sound like we have a decent market!

I put into an option calculator:

Pretty fun stuff. If the OTM call IV is discounted by 1 vol point (so -2% skew vs the 50% ATM IV @ the .27 delta option) then the theoretical call value would be $5.616 – .2575 (ie the vega) ~ $5.36

If you want more reinforcement on this I wrote a thorough twitter thread explaining vertical spread comprehension in detail.