Are SPX Options Expensive?

Options are non-linear financial products that allow you to do useful things that you can’t easily do with other financial instruments.

Let me give a specific illustration of options being useful…

The chart below shows the monthly cumulative % performance of our RW systematic trading portfolio since we started trading it in October 2018.

The orange line shows our  performance. The blue line shows the performance of global stocks (VT) over the same period:

You can see we’ve done pretty well over the period.

But I don’t show you this just to brag. There’s a point coming, I promise…

What’s in that portfolio?

We’re maximalists. We run a diversified range of multi-asset, multi-style strategies in there.

  • There are a few risk premia harvesting strategies – including the one from our public Risk Premia Bootcamp.
  • There are a number of systematic alpha strategies – including the FX strategies and pairs trading strategies from our Bootcamps, as well as some other systematic and semi-systematic alphas in stocks, futures and options.
  • There is a little bit of discretionary trading.
  • There are static and tactical hedges – using options, volatility products, and (occasionally) interest rate futures.

Over the last two months, most of the systematic strategies we trade did quite badly. Yet we’re up significantly. What gives?

Well, one of the main benefits of options contracts is that they have convex payoffs.

Being long options tends to be helpful when everything goes haywire because you can put on positions which have a lot of upside when things move a lot, and limited downside when they don’t.

The grey line shows what our trading P&L would look like if we excluded the P&L from our options positions.

You can that the real benefit to our options trading came in the last two months.

Our February wasn’t much fun, but it would have been a lot less fun without our options positions in place! ​

Options are useful, and they allow you to do useful things if you treat them with respect.

A common comment we receive from our members about options looks something like this:

“I want to hedge my portfolio risk by buying puts, but they seem way too expensive right now.”

Well, let’s see if that is actually the case. We’re going to look at SPX index options.

Do they really seem “expensive” right now?

We’re going to “finger-in-the-air” this. Nothing is precise in the markets and we often have to make quick decisions.

How can we make a quick judgement on whether SPX options seem “expensive” right now?

Well, we’re going to use the VIX index to get a quick estimate on how the options market is pricing the next 30 days volatility.

The VIX is about 60% at the time of writing. That means that the SPX options market expects the volatility of SPX over the next 30 days to be about 60%.

To determine whether that seems “expensive” or “cheap” we’re going to need to forecast what we think the volatility of SPX is going to be over the next 30 days, and compare it to VIX.

  • If our forecast is significantly less than 60% then we might say that SPX options are “expensive” (on average)
  • If our forecast is significantly more than 60% then we might say that SPX options are “cheap” (on average)

There are many ways to forecast volatility. One of them is to plot rolling SPX volatility over a period of time and eyeball it. In doing this, we must consider a few things:

  • volatility is likely to stay close to its most recent estimate
  • but it’s also likely to revert to its long-run mean value slowly over time
  • unless it spiked on a highly unusual uncertain event which has now passed, in which case it is likely to revert quickly
  • volatility is negatively correlated to moves in the index. It tends to increase when SPX declines.

“Eyeballing” rolling volatility charts with these features in your mind is a decent, pragmatic, approach to forecasting volatility.

Another (not necessarily better) approach is a time-series forecasting model such as the GARCH family of models. Many of these models incorporate these effects.

The V-Lab website from NYU Stern allows you to run these models on daily close-to-close data for free without writing any code…

Here I’ve run a variety of step-ahead GARCH volatility prediction models and plotted them along with VIX (the blue line).

What do we see?

We see that everything except the EGARCH step-ahead forecast is predicting annualised SPX volatility of between 70-80%.

This is significantly higher than the current VIX level of 60% – which suggests that SPX options might still be reasonably priced, even at these elevated levels.

However, these plotted forecasts are only showing an annualised volatility forecast for the next day. VIX tells us what the options market expects the volatility of SPX to be over the next 30 days.

We can get that estimate from V-Lab with a little more work. We need to run each model and look at the 1 Month prediction.

If you do that, you’ll find that you struggle to say that SPX options are “expensive” right now, relative to the assumptions made in most GARCH forecasting models. Most of our forecasts of month ahead volatility sit comfortably above the current level of VIX.

So what does this mean for the wannabe hedger?

Options are good – and you want to lean on the side of buying options as long as they look reasonably priced.

Right now they look reasonably priced to me on a variety of estimates.

So, absent more extraordinary policy support to drive down realised vols (which might happen, but we can’t really forecast that) I think SPX options are reasonably priced  – even at these levels.

If you want option protection, you shouldn’t let high implied volatility numbers stop you from buying it.

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