Implied Correlation At Record Highs

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Implied Correlation At Record Highs

I donít think many traders follow the CBOEís implied correlation index, but lately itís been on the rise.

The implied correlation index (actually a set of two indices) compares the implied volatility of S&P 500 options (the VIX) to the implied volatilities of options for individual stocks within the S&P 500 index.

For example, on September 27, the VIX closed at 22.54%. But the implied volatility of stocks varied widely ñ with options for Procter & Gamble (PG) implying a volatility of about 15.2%, while options for Bank of America (BAC) implying a 37.3% volatility.
When the implied volatility of individual stocks tend to rise and fall in line with the VIX itself, the implied correlation gets higher.


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Not just one index
The CBOE actually tracks two indices, one for options that expire in January 2011 and another for options that expire in January 2012.

Unfortunately, this creates breaks in the data. For example, the implied correlation data from 2007 tracked options that expired in 2008 and 2009, but those options expired long ago.

So what I did was to create a weighted average of whatever two expirations were tracked on a specific day and came up with the following chart. It shows the S&P 500, the VIX, and my own version of a weighted implied correlation average.



As you can see, implied correlation (at least the way I measured it) is on the rise, with volatility for individual stocks seemingly more correlated to the VIX than any time since the CBOE tracked this information.

One thing to keep in mind is that these implied correlation indices only measure the VIX against  the top 50 stocks in the S&P 500 weighted by market capitalization. That means stocks like Apple (AAPL) and ExxonMobil (XOM) have more influence than others.

Significance of implied correlation
So what does this all mean? According to a CBOE white paper (PDF) on the topic:

Intuitively, one would expect that the implied volatility of an index option would rise with a corresponding change in the implied volatilities of options on the index components. Yet, there are times when index option implied volatility moves and there is no corresponding shift in implied volatilities of options on those components. This outcome is due to the marketís changing views on correlation.

The relationship between the implied volatilities of options on an index and the implied volatilities of a weighted portfolio of options on the components of that index, therefore, becomes a measure of the marketís expectation of the future correlation of the index components ñ the ìimpliedî correlation of the index.

This would seem to indicate that when these indices fall, diversification strategies can be more profitable than when implied correlation is rising.

Hereís another chart going back  to December of 2009. This chart displays the S&P 500, VIX, and both implied correlation indices now being tracked, one for options that expire January 2011 and the other for options that expire in 2012.



In the end, while I thought this was interesting, Iím not sure this set of indexes has enough of a track record to provide much meaningful information. And it certainly isnít creating much of a buzz. A search of Google News shows only a few references to articles on implied correlation.

And while the 50 stocks tracked for implied volatility are among the worldís largest companies, there are still thousands of stocks that arenít measured and may not be highly correlated at all.

Besides, if options are derivatives, then implied volatility is a derivative of a derivative.

Which I guess would make implied correlation a derivative of a derivative of a derivative.

And if options or futures begin trading on the implied correlation indices, you get a derivative of a derivative of ñ well, you get the idea.

Important Note : While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.


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