Not all volatilities are built equal. It is essential to differentiate between historical volatility and implied volatility, so that retail traders learn to trade options by focusing on what is material to theoretically price forward option spreads.
Historical volatility (HV) measures the past price movements of the underlying asset and records the actual or realized volatility of the asset. The best-known type of HV is statistical volatility, which calculates the performance of the underlying assets 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 statistical volatility: for example, 5-10-50-200 days, this is how time-based moving averages and momentum/oscillator studies are constructed. However, this is not the case for implied volatility.
Implied volatility measures expected values by repeatedly refining estimates of supply and demand. These estimates are based on the expectations of buyers and sellers. The buyers and sellers (more than 85% of the volume traded on the floor is driven by institutions, floor traders and market makers) behind the buy and sell values, who change their estimates throughout the day, as new information Either macroeconomic news or micro-economic data affecting the underlying product is available. What is estimated is the future fluctuation of the underlying asset with certain assumptions built into the changes in the information of the underlying. That refinement of supply and demand estimates must be completed within time-limited option expiration periods. That is why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, in order to “build” a time frame that gives you faster or slower cross indicators.
Why point out the incorrect use of the historical volatility and implied volatility crosses? It is to warn you against misusing HV-IV crosses, which is not a reliable trading signal. Remember, for a given expiration month, there can only be one volatility during that specific period. Implied volatility should break from where it is currently trading to converge to zero on the expiration date. Implied volatility (either IV for ITM, ATM or OTM strikes) must return to zero at expiration; but, the price can go anywhere (up, down or stay flat).
Continually selling “overvalued” options and buying “undervalued” would eventually cause the implied volatility of each non-zero bid option to align exactly. Which means that the “smiley” skew phenomenon of IV disappears, as IV becomes perfectly flat. This hardly happens, especially in highly liquid products. Take, for example, the SPY, a broad-based index; Gold, GLD: The SPDR Stock ETF in a fast market like gold. With open interest on non-zero bid strikes running into the thousands and tens of thousands, do you really think an off-floor retail trader will be able to “beat price” from the on-floor professional hedger? Unlikely. Calls and Puts on highly liquid products are like items in high supply inventory because there is high demand. This type of inventory does not have “wrong values” because floor traders have to make a living daily trading call and put options; they will refuse to risk overnight incorrect pricing.
So what are the key banking considerations to your advantage as a retailer?
- The percentage impact of IV on an option’s extrinsic value is much larger for ATM and OTM strikes, compared to ITM strikes that are loaded with intrinsic value but lack extrinsic value. Most retail options traders with an account size of USD $25-$50K (or less), gravitate towards ATM and OTM strikes for affordability reasons. The deeper the ITM, the wider the bid-ask spread becomes compared to the narrower bid-ask spread differences in ATM or OTM strikes, making ITM strikes more costly to operate.
- When you trade IV, you are buying decay time for an increase in IV by one percentage point below; or, by selling a time premium for a drop in IV to one percentage point above the theoretical price of the market value, which participants are willing to pay or sell. Depending on that day’s market ranges, price debit spreads fill at 0.10-0.15 below the theoretical price of the spread. With credit spreads, increase the credit to sell the spread by 0.10-0.15 above the theoretical price of the spread. The price you pay below; or receiving above the theoretical price of a spread is your advantage, based solely on the price-yield of implied volatility alone. Remember, in theory, the price has been extended to fill the order for its forward value, never the other way around.
Where can I learn to trade options with constant gains focused on implied volatility without historical volatility? Follow the link below, titled “Consistent Results” to view a retail options trader portfolio model that excludes the use of HV and focuses on trading only IV.
I will cite these actual historical facts to reinforce the argument in favor of completely removing historical volatility from your trading process.
February 27, 2007: Widespread panic over major stock sell-off in China. If you were trading options on an index like the FXI, which is the iShares product of the 25 largest and most liquid Chinese companies in China, even though they are listed in the US; but they are based in China, you would have been affected. While you can argue that it is possible for market events to recreate the ranges of the Dow, Nasdaq, and S&P, how do you recreate the sky-high 59% and 39% VIX and VXN scenario?
January 22, 2008: The Fed cuts rates by 75 basis points ahead of the January 30 policy meeting, while the FOMC cuts another 50 basis points on the meeting date. If you were trading interest rate sensitive sectors using options on a financial ETF or bank index like the BKX; or, the housing index like the HGX, would have been affected. And in today’s near-zero rate environment, the FOMC, while still having a rate policy tool, can’t cut rates by the same number of basis points as before. What was a historical event cannot be repeated successively in the future, not until rates rise again and then fall again.
Question: How is history reconstructed? That is the history of the events that make up the Historical Volatility. The answer lies in the actual examples cited, as with any other financial-related historical event: history cannot be reconstructed. You may be able to imitate parts of HV but you cannot repeat it in its entirety. Therefore, if you continue to use HV-IV crosses, you will be visually confused by looking for “bad stock” volatility patterns that you would like to see; but instead, you will end up with a poor earnings performance. It makes more practical business sense to focus solely on IV; Then, diversify trading volatilities across multiple asset classes beyond stocks.
Where can I learn more about trading IVs across multiple asset classes using just options, without having to own shares? Follow the link below (video-based course), which uses IV Mean Reversion/Mean Repulsion and IV Forecast, as reliable methods for trading implied volatilities on broad-based stock indices, commodity ETFs, ETFs currencies and ETFs from emerging markets.
