Japanese stocks have been on a tear since last November. The Nikkei 225 index is up nearly 25%.
Most of the time, stock returns and option implied volatility move in opposite directions. Since 2007, the correlation of daily S&P 500 returns and the VIX was -0.768. The intuitive explanation for this relationship is that equity holders are less likely to raise their bids for options when stocks are stable or are rallying. Based on that relationship, and given the size of the equity rally we’ve seen recently in Japan, you might expect options on the Nikkei to be trading particularly inexpensively. But that’s not what has been happening.
Fig. 1. Nikkei 225 prices and 1-month implied and historical volatility. Source: Nikkei, Condor Options
Instead, the stock rally has been so strong that the standard deviation of returns has actually risen over the period, and options have been re-priced accordingly. In the lower panel of fig. 1, you can see the typical relationship playing out as stocks sold off in the spring of 2012: stock volatility rose and by mid-May, options included a substantial premium.
Fig. 2. 1M N225 volatility risk premium. Source: Nikkei, Condor Options
The volatility spike above 25% in 2013 is remarkable not just because it is occurring along with an equity rally, but also because the volatility risk premium is the lowest it has been for some time. The median ratio between 1-month Nikkei option implied volatility and trailing stock volatility is 1.26, meaning that the options typically trade at about a 26% premium to historical stock movements. Since late January, however, option prices have been stickier than usual, and the ratio has been less than 1.
Fig. 3. 3M skew vs. ATM implied volatility. Source: BNP Paribas
From a trading perspective, it’s easier to reason from the trades we hate and then do the opposite. Owning naked calls on Japanese equity looks terrible on a risk-adjusted basis, even for bullish investors, since a short-term reversal or even a pause in the rally should see option IV come in considerably. Nikkei IV skew is low compared with other global indexes (fig. 3), though higher OTM call bids probably explain most of that – a call vertical is not so bad, and short put verticals look even better for bulls who aren’t quite as bullish for the short term. From a bearish perspective, puts aren’t cheap, either, and hedgers can do better in Asia ex Japan or with an explicit yen trade.
Fig. 4. CME yen futures volatility skew, 02/08/2013 & 01/24/2013. Source: CME
We can’t conclude without looking at the yen, which is the assumed proximate cause of unusual equity vol behavior here. The possibility of a trend reversal around the G20 meeting or BOJ governor nomination this month is on the minds of many, and per fig. 4 the option-implied probability of a reversal is much higher than it was even in late January. (CME 6J moves opposite to USDJPY, so higher call skew reflects higher bids for a decline in USDJPY.)
Disclosure: EWJ, FXY, 6J, NKVI