Chapter 36: The Basics ol Volatility Trading 737 
It's important for anyone using implied volatility in his trading decisions to 
understand that the range of past implied volatilities is important, and to realize that 
the volatility range expands as time shrinks. 
IS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY? 
The fact that one can calculate implied volatility does not mean that the calculation 
is a good estimate of forthcoming volatility. As stated above, the marketplace does not 
really know how volatile an instrument is going to be, any more than it knows the 
forthcoming price of the stock. There are clues, of course, and some general ways of 
estimating forthcoming volatility, but the fact remains that sometimes options trade 
with an implied volatility that is quite a bit out of line with past levels. Therefore, 
implied volatility may be considered to be an inaccurate estimate of what is really 
going to happen to the stock during the life of the option. Just remember that implied 
volatility is a forward-looking estimate, and since it is based on traders' suppositions, 
it can be wrong - just as any estimate of future events can be in error. 
The question posed above is one that should probably be asked more often than 
it is: "Is implied volatility a good predictor of actual volatility?" Somehow, it seems 
logical to assume that implied and historical (actual) volatility will converge. That's 
not really true, at least not in the short term. Moreover, even if they do converge, 
which one was right to begin with - implied or historical? That is, did implied volatil­
ity move to get more in line with actual movements of the underlying, or did the 
stock's movement speed up or slow down to get in line with implied volatility? 
To illustrate this concept, a few charts will be used that show the comparison 
between implied and historical volatility. Figure 36-4 shows information for the 
$0EX Index. In general, $0EX options are overpriced. See the discussion in 
Chapter 29. That is, implied volatility of $0EX options is almost always higher than 
what actual volatility turns out to be. Consider Figure 36-4. There are three lines in 
the figure: (a) implied volatility, (b) actual volatility, and (c) the difference between 
the two. There is an important distinction here, though, as to what comprises these 
curves: 
(a) The implied volatility curve depicts the 20-day moving average of daily compos­
ite implied volatility readings for $0EX. That is, each day one number is com­
puted as a composite implied volatility for $0EX for that day. These implied 
volatility figures are computed using the averaging formula shown in the chapter 
on mathematical applications, whereby each option's implied volatility is weight­
ed by trading volume and by distance in- or out-of-the-money, to arrive at a sin­
gle composite implied volatility reading for the trading day. To smooth out those 
daily readings, a 20-day simple moving average is used. This daily implied volatil-