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