Clearing Up Some Common Volatility Misunderstandings

Options volumes and open interest have been moving up steadily. Charts of their growth may not be as dramatic as those of your favorite penny stocks or cryptocurrencies, but they too have risen to records. As an ever-increasing number of investors gravitate to listed equity derivatives, I also hear some misconceptions about the topic. I believe it is important to clear up some common misunderstandings about volatility that occur in financial media. 

Historical volatility is too low

It is important to understand what historical volatility represents. It is a statistical measure of the dispersion returns of returns for an underlying share or index, usually calculated with standard deviation. What many investors fail to understand is that the historical volatility can be measured over different time periods. Consider the following graph:

S&P 500 Index vs. Implied and 7, 20, 60 and 200 Day Historical Volatilities

S&P 500 Index vs. Implied and 7, 20, 60 and 200 Day Historical Volatilities

Source: Bloomberg

We can see how the measures differ depending upon how long of a time period we choose.It is clear that the 200 day volatility is declining as the events of the spring recede from the calculation.Successful volatility trading requires the trader to consider the relationship between the implied volatility of their desired options and the historical volatility that best matches the time to expiry of their options.

Implied Volatilities are Too High.  

When we look at the graph above, we see that the implied volatility of 17.935 is significantly higher than the 20 day historical reading of 10.432.Since the implied volatility shown above is for at-money options with a 30 day life, and 30 calendar days encompass about 22 trading days it is relevant comparison.That certainly seems high.Is the market crazy?In my experience, index options markets are rarely crazy.Traders are clearly anticipating that volatility could increase during the ensuing 30 days.Remember that we are exiting a holiday period and entering a few weeks that encompass a potentially testy Inauguration, quarterly earnings season, and a late January Federal Reserve meeting.All are potential volatility catalysts.Traders can certainly take a view that the implied volatility is indeed too high, but that is more a matter of reasonable debate than a prima facie mistake.

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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