Understanding volatility is an essential tool in your macro toolkit. At Hedgeye, we have a nuanced view about how to incorporate this measure into your portfolio decision-making process.
Due to popular demand for a primer on the topic, we produced a special video a few weeks back, “Understanding Volatility,” with Macro analyst and resident volatility guru Ben Ryan specifically for subscribers of The Macro Show. We know you’ll find value in Ben’s explanation.
As an added bonus, we’ve included Ben’s response below to a subscriber who wanted to dig a little deeper. Their discussion relates to the relationship between “realized volatility” (i.e. historical volatility of an asset over some set time period of time) and “implied volatility” (i.e. investors’ expectations of future volatility, implied in futures and options markets).
By taking the pulse of implied relative to realized volatility, we can get a good read on whether investors are becoming more fearful or more complacent.
- Fearful: Expectations of future, implied volatility are in excess of the historical, realized volatility because investors are seeking downside protection on that asset in options markets. That’s called an implied volatility premium.
- Complacent: Expectations of future, implied volatility is below historical, realized volatility because investors are going long that asset in options markets. That’s called an implied volatility discount.
Here’s Ben’s response, laying out our contrarian view on volatility signals, to our inquisitive subscriber:
“Thanks for watching the clip and thanks for the question. We’re always glad to see subs are engaged.
When we talk about “implied volatility premiums” we are comparing implied volatility (forward looking volatility expectations) to realized volatility (backward looking).
So if realized vol is 10% and implied vol is 15%, that’s a 50% implied volatility premium.
We were saying that if the implied volatility premium is widening out (getting larger), the market is saying that the current price action and trading environment will not last. A higher volatility assumption = more expensive options prices (insurance premiums are going up). Therefore a higher volatility assumption will get priced in when investors are nervous about a correction.
We never want to look at a single factor in a box like an implied volatility premium, but we can both agree that as an investor you have to be non-consensus and accurate more often than not. Therefore, if an implied volatility premium is positive and getting larger, it’s very possibly a sign that the market is not ready to correct – volatility is inversely correlated to a market most of the time. Volatility picks up when a market goes down.
Let me know if that makes sense because we want subs to understand our process here. Thanks again for reaching out.”
