When equity markets correct, the term volatility appears more frequently and referred to more in television news, the financial press and even in Twitter tweets. As a result, it is increasingly associated with market declines and not often associated with advances – all very understandable.
However, since there are several meanings and usually not specifically defined a review may be helpful to clear up some confusion.
In the world of listed tradable options on financial instruments rising volatility generally means options prices, called premiums, are increasing resulting in higher values for the volatility measure called Implied Volatility (IV), a value derived by an options pricing model like the Black-Scholes. Using the current price of the underlying security, the exercise price, time to expiration, interest rates, and dividends, they compute implied volatility values for each option based upon actual market prices. Although we know prices of underlying securities often trend, there is no explicit variable in the models for trend as they assume prices randomly go up one day and down the next. Further, they assume the magnitude of the up and down moves are log normally distributed where the daily price changes cluster around the average.
Since actual options prices are an input into the model Implied Volatility reflects expectations regarding the movement of the underlying either up or down and can help to gauge if options are cheap or expensive relative to the recent movement of the underlying and relative to a long-term mean value. In addition, each option contract has a unique level of Implied Volatility, which can change over time as the demand each option rises or falls.
By deriving a value for implied volatility from the actual option prices, we are asking it to carry a heavy burden. For example, when there are more buyers than there are sellers for options or anything else, prices increase causing higher implied volatility. However, implied volatility can also increase due to the relative bargaining power between buyers and sellers. For example, market makers will attempt to keep prices high enough to cover their added risk of making two-way markets especially when the trading volume is low. In addition, implied volatility has a tendency to decline as the underlying securities trend higher and inversely increase when the underlying securities decline reflecting a change in the risk assumptions by those willing to pay higher put prices for downside protection. Therefore, implied volatility assumes by default the task of encapsulating a single value for known and unknown variables including fear and greed as well any trend component.
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The second important volatility measure, called Historical Volatility (HV), also Statistical Volatility (SV) or Realized Volatility, all refer to the past price movements of the underlying asset, and hence the term “Historical” seems to remain the most popular. The most frequently used definition for Historical Volatility is a one standard deviation price change, computed from close-to-close price data, annualized. An alternative computation method, referred to as Parkinson’s Historical Volatility, includes the price range for each observation in the calculation thereby better reflecting intraday price movements.
From the perspective of an options trader or strategist, forecasted Implied and Historical Volatilities are the most important and the least publicized. Option premiums rise when market participants expect greater stock price movement. When the Historical Volatility of a stock or index is high, there is a tendency for the market to drive option premiums high as well. Since Implied Volatility is forecasting the expected future Historical Volatility and like many other forecasts it can be wrong due to unforeseen circumstances. However, some useful observations can be helpful when attempting forecast volatility, one of the most important is that volatility is mean reverting, as both measures tend to return to “normal” levels after reaching extremes, either high or low. Therefore, a strategist will look to sell volatility when perceived to be high and buy volatility when perceived to be low.
Since Historical Volatility is a one year, one standard deviation price change of the stock, ETF or index and Implied Volatility represents the same period then comparing their differences may used as the basis for trading plans by determining if option prices are expensive or cheap relative to the recent movement in the price of underlying asset. Although technically and incorrect, imagine this example. One way to think about the volatility relationships is to make compare local and express trains assuming express tickets sells at a premium. Using this example, an express ticket costs more but it gets you there quicker. The local ticket is less expensive, but it will take longer to arrive. Imagine to your delight if you bought the less expensive local ticket only to discover all the trains running that day were express trains. That is, you bought an option when the Implied Volatility was either less than the Historical Volatility at the time of purchase or the Historical Volatility accelerated faster than was priced by the Implied Volatility.
If this is not confusing enough, there is another way the financial media may refer to volatility. Since rising Implied Volatility is synonymous with increasing options prices and because of their use in hedging applications Implied Volatility represents the cost of hedging, so increasing volatility may be expressing the rising cost of hedging as option prices rise during periods of increasing uncertainty.
Volatility Kings™ is a list of companies we compile that have a tendency to experience increasing option implied volatility as their quarterly reporting dates approach. Increasing implied volatility reflects uncertainty or the width of the possible stock price distribution on the report date. However, the degree of uncertainty for the current report may not be comparable. Indeed, some companies are on the list one quarter and not the next while others seem to remain on our list quarter after quarter. Since earnings reports reoccur every quarter, multiple opportunities may be available, especially for those that experience a regular pattern of rising implied volatility into the report dates.
As for earnings reporting, the typical pattern is for implied volatility to decline for 4-6 weeks after a report date followed by a subsequent rise for about 3-4 weeks before the next report, but they vary with each having its own unique pattern.
Option prices continuously change in response to changing expectations and the higher the uncertainty the more valuable the option, implying there is a much wider distribution of possible outcomes. When they become more predictable, the implied volatilities no longer increase dramatically before the reporting dates and option volume usually declines.
Individual investors relying upon the earnings forecasts and playing the expectations game wondering if they may be too high or too low are disadvantaged when anticipating the direction the stock will move after reporting. However, if the implied volatility has risen enough into the report date it may offer an opportunity for a volatility strategy not relying entirely on getting the direction right.
Frequently calendar spreads, also called time spreads are used for quarterly reporting by selling the near term option with higher implied volatility and buying the same strike price in the deferred month with a lower implied volatility. However, since this position will have short gamma or the rate of change of delta, any large move of the underlying on the report date will result in a loss.
An alternative calendar spread approach, distinguished by the expiration date of the short option relative to the earnings report date has quite different characteristics.
This strategy depends on closing the spread position one or two days before the short option expires and is thus, truly a time spread designed to capture time decay of the short front option relative to the long option while any implied volatility advance of the deferred option is a bonus. When the short option expires before the report date, the short option implied volatility is less likely to advance while the implied volatility of the deferred long option, expiring after the report is more likely to advance into the earnings report. In addition, the risk of a harmful stock price gap diminishes by closing the spread before the earnings report release.
Those interested in comparing changing implied volatilities for different periods will find volatility charts displaying implied volatility and historical volatility computed for periods beyond the standard 20 or 30 days useful. For example, by comparing 30-day volatility charts to those for 60 days may show the shorter term implied volatility rising as the longer term remains static reflecting an upcoming reporting date. Comparing the confirmed reporting dates using volatility charts for both periods will help determine the best option combination with the highest probability for success.
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