Author: Clinton Lee.
Not
all volatilities are constructed equal.
It is critical to differentiate between Historical Volatility and
Implied Volatility, so retail traders learn how to trade options focused on what
is material to theoretically price option spreads forward.
Historical
Volatility (HV) measures past price movements of the underlying asset recording
the asset's actual or realized volatility. The more commonly known type of HV is Statistical
Volatility, which computes the underlying assets return over a finite but
adjustable number of days. Let me
explain what “finite but adjustable” means. You can vary the number of days to measure the Statistical
Volatility: for example, 5-10-50-200 days, that’s how time-based moving
averages and momentum/oscillator studies are built. Though, it is not the case with Implied Volatility.
Implied
Volatility measures expected values by repetitively refining bid-ask
estimates. These estimates are
based on the expectations of buyers and sellers. The buyers and sellers (85+%
of floor traded volume is driven by institutions, floor traders and market
makers) behind the bid and ask values, who do change their estimates within the
day, as new information be it macro-economic news or micro-economic data
impacting the underlying product becomes available. What is being estimated is the underlying asset’s future
fluctuation with certain assumptions embedded into the changes in information
of the underlying. That refinement
of bid-ask estimates must be completed within finite time-bound option
expiration periods. That’s why there are monthly and quarterly option
expiration cycles. You cannot change these expiration periods, either by
shortening or lengthening the number of days, to “construct” a time period that
gives you faster or slower crossover indicators.
Why
point out the wrong use of Historical Volatility and Implied Volatiity
Crossovers?
It is to caution you against the defective use of HV-IV crossovers, which is not a reliable trading
signal. Remember, for a given
expiration month, there can only be one volatility over that specific
period. Implied Volatility must
leave from where it is currently trading at, to converge at zero on expiration
date. Implied Volatility (be it IV for ITM, ATM or OTM strikes) must return to
zero on expiry; but, price can go anywhere (up, down or stay flat).
To
continually sell “overpriced” and buy “under priced” options would eventually
cause the implied volatility of every single non-zero bid option to line up
exactly. Meaning the phenomenon of
IV’s “smiling” skew disappears, as IV becomes perfectly flat. This hardly
happens, especially in highly liquid products. Take for example, the SPY, a
broad-based Index; or, GLD – the SPDR Shares ETF in a fast market like Gold.
With open interest at the non-zero bid strikes going into the thousands and
tens of thousands, do you really think a retail off the floor trader is going
to be allowed to “out price” the professional hedger on the floor? Unlikely. Calls and Puts in highly
liquid products, are like items in an inventory with high supply because there
is high demand. This type of
inventory does not get “mispriced” because floor traders have to make a daily
living from trading the Calls and Puts - they will refuse to carry the risk of
mispricing overnight.
So,
what are the key considerations to banking in your edge as a retail trader?
❑ IV’s percentage impact on an option’s
extrinsic value is much more sizeable for ATM and OTM strikes, versus ITM
strikes which are laden with intrinsic value but lack extrinsic value. Most retail option traders with an
account size USD $25-$50K (or less), gravitate towards ATM and OTM strikes for
reasons of affordability. The
deeper the ITM you go, the wider the Bid-Ask spread becomes compared to the
narrower Bid-Ask spread differences in the ATM or OTM strikes, making ITM
strikes more costly to trade.
❑ When you trade IV, you are buying
time decay for a rise in IV at a % point below; or, selling time premium for a
drop in IV at a % point above the theoretical price of market value, that
participants are willing to pay or sell for. Depending on the market ranges of that day, price debit
spreads to get filled at 0.10-0.15 below the Theoretical Price of the
spread. With credit spreads, raise
the credit to sell the spread by 0.10-0.15 above the Theoretical Price of the
spread. The price you pay below;
or, receive above the Theoretical Price of a spread is your edge, purely based
on price-performance of Implied Volatility alone. Remember, you Theoretically
Price a spread to fill the order for its forward value, never backward.
Where can I learn how to trade options with consistent profits
focused on Implied Volatility without Historical Volatility? View Consistent Results, to see a model retail option trader’s portfolio
that excludes the use of HV and focuses on trading only IV.
I’ll cite these
actual historical events, to bolster the argument for removing Historical
Volatility from your trading process altogether.
27
Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. If
you were trading the options of an index like the FXI which is the iShares
product of China’s 25 largest and most liquid Chinese companies though listed
in the US; but they are headquartered in China, you would have been impacted.
While you can argue it’s possible to have market events recreate the ranges of
the Dow, Nasdaq & S&P, how do you recreate the scenario of the VIX and
VXN soaring 59% and 39%?
22Jan,
2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting
on Jan 30th, whereby the FOMC cut another 50 basis points on the date of the
meeting. If you were trading
interest-rate sensitive sectors using the options on a Financial ETF or a
Banking Index like the BKX; or, the Housing Index like the HGX, you would have
been impacted. And in the current environment of rates being near zero, the
FOMC while they still have a rate policy tool, they are unable to cut rates by
the same number of basis points like before. What was a historical event is not
successively repeatable going forward, not until rates are raised again and
subsequently they get cut again.
Question:
How do you reconstruct history?
That is the history of events forming Historical Volatility. The answer is in the real examples
cited, as with any other financially related historical event - you cannot reconstruct
history. You may be able to mimic parts of HV but you cannot repeat it in its
entirety. So, if you continue
using HV-IV crossovers, you visually confuse yourself by searching for
volatility “mispricing” patterns that you would like to see; but, you will end
up with poor profit performance instead.
It makes more practical trading sense to focus purely on IV; then,
diversify the trading of volatilities across multiple asset classes beyond
equities.