Why XLF volatility is 67% greater than SPX Volatility…

Most options market makers, when they begin their career as true traders, first learn to remain as delta neutral as possible, whilst trying to capture edge – selling at a premium or buying at a discount to an option’s theoretical value at the moment of the trade.

This theoretical value is ever-changing and there is no “right price” for an option ever that still contains time value, because one never knows what will happen.  In other words, NO ONE knows exactly what the time value of an option should be.

To simplify, time value is determined by the amount of implied volatility assigned to that option, in addition to days until expiration, dividends, and interest rates.  Another word for time value is “risk premium.”  Options are not only used to speculate on a stock’s move, but also to provide protection either to the upside or the downside.

This protection factor is the reason why out-of-the-money puts tend to be more expensive than their same-delta call cousins, which are also out-of-the-money.  This is not a hard-and-fast rule, but tends to be the norm, rather than the exception.

Think about your friends who invest and trade stocks.  Chances are that a greater percentage of them tend to be long side traders, or they typically prefer to be long stock versus short stock.   This is a normal psychological tendency as well, both from a logical perspective (one would typically want to buy good American companies as we are taught this from our early market education)  and from a risk perspective (if you pay $30.00 for a stock, you know no matter what happens, you can only lose that $30, whereas when you short stock at $30.00, your loss potential is theoretically unlimited.  This can be hard for most human minds to quantify and thus most shy away from this practice.).

The bottom line is that because most of us tend to take long positions, the put provides the only downside protection for us and thus costs more typically, because the fear of a stock going to zero is often a more widespread fear compared to the fear of a stock doubling in value.  Remember, like stocks, supply and demand drive options prices.

This is why puts tend to cost more than calls of the same delta, when they are out-of-the-money.  Now on to the original question posed.

Why is implied volatility for the Financial Select Sector SPDR (XLF) (vol mean 34.63%)  about 67% greater than the implied volatility for the S&P 500 Index (SPX) (vol mean 20.69%)? As all of the stocks in the XLF are part of the S&P, one might think they should be much closer.

This gets back to some simple logic and some other not-so-simple algorithms.  The SPX is comprised of 500 unique stocks in several different sectors.  The chances of all these stocks moving in perfect unison in one direction or the other is much less than a small group of, say, 30 stocks.  Thus the larger sample size of companies offer a quasi-hedge to one another and thus lower implied volatility or risk premium, because essentially there is less risk of a catastrophe affecting such a large collection of issues.

In the XLF,  you have a concentrated index of companies in the same sector (a sector that has recently been more volatile than in the past).  This increases your exposure and reduces your hedge, and the chance of a catastrophe affecting that index increases due to the lack of a hedge.  So aside from the fact that financials have been a mess for the past two years, a smaller, focused index will tend to have a higher implied volatility than a larger, more diversified one.

In just about all cases, implied volatility tends to be higher than the actual observed volatility, which is why most professional options traders tend to be better sellers of options, while having limited delta exposure,  I know I am.

Cheers!