60  •   The Intelligent Option Investor
it is because it is also the definition of the BSM cone. To the extent that 
expectations are not directly observable, forward volatility can only be 
guessed at.
The option market’s best guess for the forward volatility, as expressed 
through the option prices themselves, is known as implied volatility. We 
will discuss implied volatility in more detail in the next section and will 
see how to build a BSM cone using option market prices and the forward 
volatility they imply in Part III.
The one other measure of volatility that is sometimes mentioned is sta-
tistical volatility (a.k.a. historical volatility). This is a purely descriptive statis-
tic that measures the amount the stock price actually fluctuated in the past. 
Because it is simply a backward-looking statistic, it does not directly affect 
option pricing. Although the effect of statistical volatility on option prices 
is not direct, it can have an indirect effect, thanks to a behavioral bias called 
anchoring. Volatility is a hard concept to understand, let alone a quantity to 
attempt to predict. Rather than attempt to predict what forward volatility 
should be, most market participants simply look at the recent past statistical 
volatility and tack on some cushion to come to what they think is a reason-
able value for implied volatility. In other words, they mentally anchor on the 
statistical volatility and use that anchor as an aid to decide what forward vola-
tility should be. The amount of cushion people use to pad statistical volatility 
differs for different types of stocks, but usually we can figure that the market’s 
implied volatility will be about 10 percentage points higher than statistical 
volatility. It is important to realize that this is a completely boneheaded way 
of figuring what forward volatility will be (so don’t emulate it yourself), but 
people do boneheaded things in the financial markets all the time.
However people come to an idea of what forward volatility is rea-
sonable for a given option, it is certain that changing perceptions about 
volatility are one of the main drivers of option prices in the market. To 
understand how this works, let’s take a look at what happens to the BSM 
cone as our view of forward volatility changes. 
Changing Volatility Assumptions
Let’s say that we are analyzing an option that expires in two years, with a 
strike price of $70. Further assume that the market is expecting a forward