Option volatility skew illustrates which direction the implied risk lies in an underlying security
The rule of 16 can help investors determine whether market movement and measured volatility are in line
Modern investors get frequent updates on where the Cboe Volatility Index (VIX) is trading. Some even refer to the VIX as the “fear index” because it typically rises when the broader stock market falls.
In fact, advanced traders can even trade futures and options on the VIX. But for all the attention it gets, few investors really understand this measure of options volatility, what it means, how to measure it, and finally, how to determine its most accurate value.
What’s the Rule of 16?
The VIX was introduced by the Cboe in 1993 as a weighted measure of the implied volatility (IV) of the S&P 100 Index. In 2003, the VIX expanded to measure the S&P 500 Index (SPX). The VIX quickly evolved into the preeminent measure of investor fear and overall market volatility.
As investors monitor the VIX on a daily and weekly basis, they’re simply watching a number that represents the IV of the SPX. Without getting into a long math discussion involving square roots, let me simplify an interesting aspect of the VIX: the number 16 (or more precisely, 15.87) is approximately the square root of 252 (the number of trading days in a year). This is where the rule of 16 comes from.
While you let that sink in, let’s walk through some hypotheticals. If the VIX is trading at 16, then 68.2% (or two-thirds) of the time, it might trade up or down by less than 1%. The other 31.8% (or one-third) of the time, the SPX might trade up or down by more than 1%.
Now let’s go further. The VIX at 24 might equate to a 1.5% move in the SPX 31.8% (one-third) of the time. A VIX at 32 might equate to a 2% move in the SPX 31.8% (one-third) of the time.
The options rule of 16 works the other way, too—you can “annualize” a daily reading by multiplying it by 16. For example, suppose a stock has had a few moves of 1.8%, and you think a 1.8% daily move might be typical in the near future. If so, you would be expecting an annualized volatility level of 1.8 X 16 = 28.8%. Comparing your expectation to the current IV might indicate whether you believe an option is overpriced, underpriced, or fairly priced.
Volatility Skew: Just the Facts
Now that we’ve discussed the rule of 16, let’s tackle options skew.
Skew shows up when out-of-the-money (OTM) put IV is at a higher level than OTM call volatility, causing higher premiums on the put side. This comes from the perception that stocks fall faster than they rise.
The options volatility skew illustrates which direction the implied risk lies in an underlying. There is, of course, a supply and demand variable that determines if there’s a skew and how severe that skew (or IV differential) is. Without this demand, skew would not exist, because supply and demand for options is the clearest driver of IV.
Recognizing the existence of skew is the first step to considering it in your trading. With extra premium in OTM puts and conversely lower premiums in OTM calls, strikes can be chosen to potentially enhance trades using the divergence that skew imposes on options markets. Skew allows investors to push the put strike further out than a corresponding call side, providing less downside exposure.
In rare but very informative cases (stock splits or potentially positive news events), skew can flatten or even slightly shift positive to the call side (OTM calls with higher IV than OTM puts).
And what about the options world beyond equities, such as options on futures? Some products can behave, and thus be priced, quite differently. Options on commodities such as corn, cattle, and crude oil, for example, might have a natural upside skew, with OTM calls having a higher IV than OTM puts. It makes sense, right? Food and energy scarcity can lead to frenzied buying.
Other contracts, such as some foreign currencies, have no “natural” options skew, and skew can vary depending on market conditions, expectations, and the supply and demand of upside versus downside options.
Dig Below the Surface
General measurements of volatility such as the Cboe VIX, the rule of 16, and options skew don’t necessarily tell the entire story as to whether an option might be overpriced or underpriced. Rather, they should be considered in the context of the bigger picture. Is a company or one of its competitors about to report earnings, declare a dividend, or take other corporate action? Is there a merger or acquisition in the works?
And remember, a volatility reading only defines a statistical tendency. It’s the odds of a particular occurrence, and not a sure thing. But understanding VIX, skew, and the rule of 16 can at least offer some perspective to help make sense of the numbers.
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