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
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.
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
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
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.