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What are the different types of volatility and how may they benefit you in Option Writing trades? June 28 2021What are the types of volatility, Options writers

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What is Volatility ?

Volatility is an important factor in the decision-making process when it comes to trading options. Although it has a mean-reverting pattern, volatility can be extremely turbulent at times. It has fat tails, with large spikes seen on black swan events that can be multiples of the mean number.

Many methods exist for calculating volatility, but three types - future-realized, implied and historical volatility are the most popular and widely utilized in decision-making.

Before we go into the intricacies, it's essential to appreciate the importance of volatility from the viewpoint of an option writer.

Volatility for option writers

Types of Volatility

The risk of rising volatility is a concern for option writers who hold short positions in calls and puts. They are short on volatility, so if it rises, they could take a loss. As an option writer, you'd want to write options when volatility is high, but this isn't always the case, as volatility tends to linger at lower levels within a given regime.

Because of this volatility's behavior, it's critical to keep a watchful eye on the number, and if it starts to rise, it might be a good idea to exit or modify your trades to avoid a volatility spike.

Let's look at how the three types of volatility can be used to predict a potential volatility spike.

Future Realized Volatility

This is the volatility of what will occur in the future. This cannot be predicted in advance, but looking at past track it can give an insight of how well the market anticipated volatility in the future.

This strikes as a distinction between Implied Volatility and Future Realized Volatility. The indicator will not be current because the rolling number of days will act as a lag, but the difference can provide signals if the underlying begins to outperform market expectations, and it will usually show a serial correlation in those circumstances. This could indicate that you should avoid writing trades or write with hedges in place.

Implied Volatility

The market's implied volatility (IV) is what it expects to happen in the future. This is the price at which you will trade in the market, and because the market is so huge, you will be a price taker. Although some technical or quantitative indicators can be used to forecast implied volatility's direction, what happens in the future may be totally different.

 You can keep track of IV in combination with historical and future realized volatility. This means that the difference between implied and historical volatility can help you determine whether you need to worry or whether there is an opportunity. In situations of known events such as outcomes, monetary policies, fiscal policies, and economic data releases, the difference between IV and HV may not be a reliable indicator.

Historical Volatility

The standard deviation of the underlying's annualized daily returns is referred to as historical volatility. To maintain a recency bias, it's typically calculated on a rolling basis.

Historical volatility has no bearing on option pricing because it is calculated solely on the basis of underlying prices. However, if the underlying prices become more volatile, it signals that future volatility may rise. As a result, rising historical volatility can be a sign of impending spikes.

Although this data is backward-looking, due to the time-series correlation seen in financial markets, looking at previous trends can still be beneficial.

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