I posted this to TheStreet.com today and feel like it's worth a read for everyone.
Option trading is volatility trading – and now it’s time to master the subject.
CBOE is going to produce a VIX type calculation for a five stocks starting Jan 7th. It turns out that Livevol, Inc has been computing and publishing a similar number for the last 2 years for every company on all exchanges in real-time for every tick with 7 years of back fill history.
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Here’s the CBOE announcement:
The Chicago Board Options Exchange (CBOE) today announced that for the first time it will apply its CBOE Volatility Index® (VIX®) methodology to options on individual stocks when it begins publishing volatility values on five highly active equities on Friday, January 7. CBOE will calculate values for Apple (VXAPL), Amazon (VXAZN), IBM (VXIBM), Google (VXGOG), and Goldman Sachs (VXGS).
CBOE remains on the cutting edge of vol indexing. It’s a very good idea, a very useful idea, but not a new idea. First some stuff on the VIX itself:
The VIX is a calculation of the implied volatility of the S&P 500 for a theoretical 30 day option. Since it’s always a rolling 30-day option, it’s a weighted average of two months of option vols. The VIX is also a weighted average of strikes.
Everyone knows the VIX is negatively correlated with the SPX, in plain terms, when the market tanks the S&P options become more expensive, and the VIX skyrockets. This relationship is the reason people refer to it as the “fear index”.
There are also options on the VIX. VIX options are fascinating because it’s a set of derivatives on a derivative on a derivative that measures implied volatility of options (another derivative). Here it is:
SPX -> S&P front month options -> VIX -> Vix Futures -> Vix Options
Tricky…
So, now CBOE is going to produce a VIX type calculation for each stock (or, in this case, a few stocks). As mentioned prior, Livevol has been publishing a similar number for the last 2 years on all companies and all exchanges for every tick with 7 years of back fill history. The methodology is proprietary and widely used and accepted by the institutional market. The number is called IV30®.
Taking it a step further, Livevol has also produced and trademarked IV60, IV90, IV120, IV180 and IV360. Or in English, the volatility of the hypothetical 60, 90, 120, 180 and 360 day options respectively for a specific stock.
I've included the two year IV30® charts for AAPL and AMZN below.
One question we get from our customers all the time is how we calculate the IV30®, IV60, and IV90, etc. The simple answer is with brute force. We actually calculate the implied volatility on the bid and ask for each option for each underlying, and we then do a variety of proprietary weighing techniques to help keep the index clean (saving us from things like unusual spreads and other strange market activity). When all else fails, we have to figure it out and do it manually.
Also, we use a method called “forward indexing” that helps us out greatly on issues like cost of carry for things such as dividends and negative interest rates when the underlying is hard to borrow. Forward indexing in this case is basically extracting the implied underlying price from the options prices, since the market makers as a community must have the correct cost of carry to provide a two sided market at all times. Read this as “back out the stock price from the ATM combo.”
The next step is to take the new implied future prices, and run those against each month to solve for the implied volatilities. The main quality check everyone needs to be aware of is that put-call-parity is respected and the values that the calls and puts have are approximately the same volatility, especially for the at-the-money options.
A fair question is: "How well does the SPY IV30® track the VIX?" I've included the two year overlay chart below.
The answer... Very well... Which means that the IV30® for each individual stock will also track well. The absolute difference between SPY IV30® and VIX is likely a function of using fewer OTM strikes in our methodology. We felt that using strikes several standard deviations away was more noise than actual information.
Ok, that was a bunch of detail, but why does this help people trade?
Good question. Here’s the answer:
The IV30® never approaches an expiration – it’s always a 30 day index. This removes volatility discrepancies that make charting and trend analysis essentially useless over an extended period of time. With these indices, we as traders can chart any term of volatility (short, intermediate, long) over any time period without concern over expirations, or one day earnings vols. So what?
Well, once we know what the vol has done in the past, we can make comparisons to realized stock movement and then take a stand (make a trade) on what we feel is high or low volatility. Simple adage, right? Buy low, sell high. If not for the indexing of volatility, there would be no reliable comparisons.
For those of you looking for more vol measures including more involved calculations than just “one stock and one strike at a time,” some of the largest exchanges will soon be utilizing Livevol services to calculate and publish complex derivative indexes. If you like the idea of IV30®, 60, etc, you’re gonna do cartwheels over what’s going coming down the pipe. Option trading is volatility trading – and now it’s time to master the subject.
This is trade analysis, not a recommendation.
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