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Is Long-Term Volatility Too Low? (Preview)

By Lawrence G. McMillan

The “mistake” that the market often makes is getting too complacent during rally phases. One of the signs of complacency is extremely low volatility. Part of this is unavoidable as the calculation of historic volatility necessarily yields lower numbers as the market trades at higher prices. Furthermore, short-term implied volatility will not deviate too much from realized volatility, for there are quasi-arbitrage strategies that will be put in place, holding implied volatility down. Longer-term volatilities can remain higher though – not adhering to realized volatility, but normally trading more towards the long-term average volatility of the underlying.

At the current time, $VIX is just below 14. That’s low, but not “too low.” However, if one looks at the longer-term volatilities as calculated by the CBOE’s Volatility Indices, signs of complacency are beginning to appear. Specifically, the longest-term CBOE Volatility Index is the one-year (symbol: $VIX1Y). It is currently trading at about 17.50 – quite low for long-term implied volatility estimates. Typically, if a trader asks a market maker for a quote on a one-year option, the market maker would price the option at an average long-term volatility. The long-term volatility of $SPX and other broad-based indices is normally at least 20, or even higher. That’s why volatility term structures slope upward in bull markets – because the farther out one goes, the less weight is placed on near-term (low) volatility, and the more is placed on longer-term (average) volatility...

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