A constant maturity index of implied volatility provides a point estimate for IV at a specific time to expiration – for example, 30 calendar days – by interpolating from the implied volatilities of the nearest series of listed options. Constant maturity indexes of implied volatility are valuable because they allow like-for-like comparisons of different periods in time for one security and for cross-sectional comparisons among securities that may not have listed options in the same expiration months. The most well-known constant maturity IV index is certainly the VIX, but most options traders look at constant maturity indexes for the assets they’re analyzing.
Sometimes, however, these indexes can produce estimates that would be misleading if used in isolation. Here is an example.
Sandisk (SNDK) came up on a recent scan as a potential candidate for a bullish trade: the stock is close to its 52-week highs, the company has been beating earnings estimates consistently, and short-term options are very inexpensive, with implied volatility in the 5th percentile versus the prior two years.
SNDK 3M and 1Y Implied Volatility. Source: Livevol
One thing that caught my attention was the divergence in recent weeks between short- and long-term estimates of implied volatility. The attached chart shows three-month (green) and one year (light yellow) implied volatility for the stock. Over the last two years, these estimates have traded roughly in line with one another, with gaps never larger than one or two percentage points. However, since earnings were released in late October, one year IV has remained bid at about 32%, while the three month estimate is closer to 28%.
I’d normally be inclined to interpret this as a vote of confidence from the market about the short-term future for the stock. One-year IV is already at recent historical lows, but traders are pricing shorter-term options at even lower levels. However, looking at the prices of tradable options reveals why we’re seeing this unusual gap between the two constant maturity IV indexes.
At-the-money options for January expiration are priced at around 25%. That’s even lower than the levels on the chart above, but it’s also still higher than the trailing realized volatility of the stock, which is about 20% at a one-month horizon. The reasons January options are priced so low are that: a) the holiday season is typically a quiet/bullish period for stocks, and b) January options will expire before earnings are announced later that month, so they will never get bid higher as the earnings date approaches.
Compare the January IV with the April at-the-money options, which are priced at about 32%, exactly in line with the one year estimate! Those options have earnings juice and are trading consistently with the historical pattern noted above. To arrive at a 90-day estimate of implied volatility, we could get a rough approximation by taking the mean of the January and April values to get 28.5%. The reason the 90-day implied volatility looks so low is that it is being dragged down by the January estimate. However, once February and March options are listed for SNDK, you won’t see them priced at 28%, since they’ll have the January earnings announcement to contend with. In other words, the true volatility for an option with 90 days to expiration will likely be much higher than what an interpolation would suggest.
The moral of this story is that it’s a good idea to look deeper than a given IV index and to pay attention to the prices of tradable assets. Ultimately, the price you pay is what matters.
Jared Woodard is the publisher of the Condor Options Newsletter, VXH Portfolio Tracking, and Volatility Tracker Research Reports