Information provided by the options market is the least accessible of the sources available to investors. Even though changes in the volatility surfaces of assets have been shown in the literature to provide valuable signals about future returns, the analysis of volatility is still seen as a specialist area. I have been working on a research product designed to help fill this gap, and more details about that are coming shortly, but first I think it would be helpful to explain the need.
Consider some of the widely accepted sources of valuable market insight, the sorts of information used to inform and justify investment decisions. My purpose here isn’t to decide the value of these different sources of information, just to note their status and availability:
- Fundamental analysis: This is probably the most familiar and most well-developed area of research. Critiques of sell-side equity research are in vogue these days, but I also regularly read smart analysts doing great work, especially covering complex industries where domain-specific knowledge is more important. There are also many smart analysts on the buy side. In terms of availability, there are many data providers at different levels of price and comprehensiveness, and for popular stocks, analyst coverage is even widely discussed in the media.
- Technical analysis: This is still a contentious area for investors who aren’t confident about subjective claims that can’t be made machine-readable. But many technical indicators can be tested quantitatively, and in that respect it has never been easier to extract whatever information there is in price action. There are countless providers now for charting software, there are free sources of code for indicators, and so on.
- Macroeconomic analysis has become more important than ever, given the increased role of central banks after the crisis and the increasing dependency among world economies. The FRED team keeps adding new data and improving their tools, and for understanding how to use that all that free data I wonder whether the best things an investor can do aren’t 1) reading some good texts and 2) having the discipline not to slink into the lairs of the demagogues and charlatans.
- Sentiment analysis, as distinct from the technical analysis of price, relies on other sources of information about order flow and the mood of market participants. I would include here the client flow reports provided by some asset managers and banks, and flow analysis of options trades. This is another area that is sometimes very qualitative, but I think it can be really valuable when properly contextualized.
I’m not sure which category the analysis of option implied volatility falls under; maybe it is sui generis? Whatever the label, good volatility research is harder to come by.
Information from the options market reveals more about the preferences of market participants than do price transactions in underlying assets, and that’s knowable a priori, since only the former implies specific commitments from investors about the value and likelihood of future states of the world in addition to commitments about present value.
Market participants know this, and policymakers do, too: in a conference presentation on September 20th, Minneapolis Federal Reserve Bank President Narayana Kocherlakota argued that instead of using statistical forecasts to guide decisions, policymakers should rely on risk-neutral probability density functions estimated from option prices. (Kocherlakota has given this presentation a few times since 2012, and the Minneapolis Fed maintains an area of its site showing the risk neutral pdfs for major assets along with other statistics and periodic commentary.) The statistics we can glean from option implied volatility surfaces tell us not just about the expected volatility for different assets, but also about the variance of changes in those expectations (volatility of volatility) and the difference in expectations at various time horizons (term structure). These measures offer investors information about the market that cannot be had in any other way.
However, most investors do not have access to the information or to the analysis that would allow them to benefit from it. First, the access: gleaning information from options markets means grappling with an order of magnitude more data than is needed to assess e.g. price action alone, and that much data needs careful management – not just to keep the database clean, but to turn it into actionable insight. Most investors can’t afford or don’t have access to these resources. And then second, there is the need for analysis: with the benefit of several years spent educating and trading alongside many different sorts of investors, I’m convinced that analysis is more important in this field than in almost any other area. That is, even an expertly developed volatility-based indicator will be (understandably) of little value without some further explanation of its use. Of course, these access and analysis requirements also arise in the other research areas mentioned above. But because options information is so complex, the challenge of offering investors the information that matters in a way that is useful becomes even greater where options markets are concerned.
There is plenty of competent fundamental, technical, macroeconomic, and sentiment research readily available. And there is some good research in options and volatility to be had; but most of it is performed by academics, by a few sharp sell-side groups, and by buy-side firms eager to protect their secrets. There is a gap between the options and volatility research available and the access and analysis needs of the investors who would stand to benefit from it.
I’ve been working on a product designed to help meet this need, and will have more to say about it in the coming days.