As readers of my posts on Seeking Alpha will be aware, I apply a quantitative model to options prices on index ETFs to derive market outlooks. Options prices represent bets as to the probabilities that a security will rise or fall by some amount over a specific period of time. By taking the market prices for a wide range of options, it is possible to infer the market’s consensus outlook. Details are provided here and here as well as in a number of Seeking Alpha posts over the last year. The current level of the S&P500 provides the consensus estimate of the index’s fair value. The options prices provide a consensus view as to the probabilities of future values.
Over the past year, options on SPY have been moderately bullish. By September, the outlook remained generally positive but, as I noted at the time, the projected loss potential was also substantial. 2018 ended with total return for the S&P500 at -4.6%. By late December, the options on SPY expiring in March 2019 were looking even more bullish, albeit with continued high volatility. For the YTD in 2019, the market has soared, of course, and we are looking at more than 13% so far.
Once again, I have used current options prices on SPY to derive an outlook for the S&P500. For this analysis, I am looking at options expiring in December of 2019, so this is an outlook for the balance of the year. I was able to derive a distribution of future returns such that the options prices derived from this distribution match the markets prices of a range of call and put options with an average disagreement of 3.3% of the market price. In other words, this is the distribution of future returns that reconciles the current options prices (below)
Option-implied probability of future returns on S&P500 to the end of 2019
Rather than show the distribution in the traditional form, I find that it is more useful to reflect the negative returns onto the positive axis. That way, the skewness in returns is very clear. The red dashed line is the negative returns and the solid blue line is the positive returns.As always, the returns are negatively skewed and the probability of extreme negative returns is higher than the probability of extreme positive returns of the same magnitude.
The mode of the distribution–the return with highest probability–is 6.5% for the rest of the year (from April 25th through December 20, to be precise). This is purely price return–dividends will be in addition to this. The projected annualized volatility for this distribution is 15.2%, very much in line with long-term historical averages for the S&P500. Another way to look at this distribution is in terms of the percentiles of return (the cumulative probabilities), as below.
Option-implied percentiles of price return to end of 2019
The 5th percentile return for the rest of 2019 is -25.7% (the far left point on the curve), while the 95th percentile return is 13.7%. There is a 1-in-20 chance that the S&P500 will return 13.7% or more and the same chance that it will return -25.7% or less. This skewed potential for loss is offset by the fact that there is a 65% chance of a positive return and a 35% chance of a negative return. The most likely outcome is to make money.
I have been analyzing options markets as the basis for outlooks for quite a few years. Back in 2007, the options markets were projecting that volatility was likely to double over the next year and beyond, a huge increase. In my analysis at that time, I noted that “If we see a market reversion to these levels of volatility, the results could be financially devastating for many people.” Today, implied volatility in the December 2019 options is 15.2% and the VIX, implied volatility for near-dated options, is about 13%. So projected volatility looks pretty normal and the most probable outcome for SPY is a price gain of about 6.5% to the end of the year. Even though the market has soared for the YTD, the options market suggests continued potential.
Geoff Considine on Finance and Economics 