Your Guide to Implied...The Five C's

I have been thinking about the factors that help set the implied volatility level for options on an asset. In the spirit of a catchy, if not slightly forced list, here’s what I’ve come up with. 

Implied Guide: The Five C’s

Carry - realized vol matters most! The old adage “theta is the rent on gamma” nicely ties the cost and benefits of being long optionality. When realized vol suffers, so too does the ability to manufacture trading profits through delta-neutral long option positions. Implieds follow realized. 

Credit - in the spirit of Merton, equity volatility can be spawned by the risk of default. A riskier, heavier capital structures often result in higher implied volatility for an option on the (contingent claim) equity. This “C” is generally relevant to equities and credit and we can put emerging market sovereign credits and FX in here as well. 

Calendar - this is the list of known sources of uncertainty that the market can price. Earnings, elections/referendums, economic data reports, OPEC meetings, Fed meetings, crop reports, FDA decisions and policymaker summits are examples. They are “date certain” on the calendar and options markets can reflect the uncertainty in termstructures. 

Concern - this is “date uncertain” macro angst or ebullience that reflects market mood swings. “Is the economy slowing?” “Is trade unraveling?” “Are we heading for deflation?” “Will the Fed stop tightening?” “Is positioning crowded?” are common questions entertained as part of establishing the narrative. The market can choose to react more or less to events based on its mood. 

Capital - this is unique from the others. A world flush in risk bearing capital is generally one of low option prices. Think of how inconsistent the early 2007 lows in credit spreads and VIX were with the actual risks. Capital was being stuffed into carry, pushing vol and spreads lower. On the flip side, think of how high risk premia remained during the back end of 2009 even as the market was recovering but there remained a shortage of risk bearing capital to put to work.