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Cyclical versus Historical Volatility

The interest in volatility for options trading is logical and understandable. However, the nature of volatility in not universally understood or agreed upon. In fact, it is more complex than most people believe. Options traders think of volatility coming in two forms, historical and implied.

In this belief system, historical volatility is backward-looking and refers strictly to the price behavior of the underlying. Implied volatility is an estimate of the option premium’s future degree of movement (without knowing whether it will increase or decrease). It is based on application of known and unknown factors.

The parametric version of historical volatility involves developing a series of assumptions about returns based on how price has behaved in the past. A non-parametric version is based on direct observation of recent price changes, without applying any other assumptions about future behavior. The often cited rule that “past returns do not reflect future returns” is part of the development of historical volatility.

The two versions above can be combined as a form of hybrid analysis. However, both are based on recent prices and involve specific and known outcomes. Implied volatility relies on estimates of future option premium behavior and is not based directly on historical changes. However, known past volatility is likely to influence the assumptions applied to develop the estimate. Implied volatility is intended to predict and is based on the controversial Black-Scholes pricing  model. This model contains numerous flaws, the greatest of which is implied volatility and the methods for arriving at its assumptions.

But there is more.

Most traders do not consider cyclical volatility in attempts to pin down likely future premium movement. In fact, beyond variance over time, in one important respect, volatility is predictable. One profound observation revealed that when it comes to how price behaves, “large changes tend to be followed by large changes- of either sign – and small changes tend to be followed by small changes.” [Mandelbrot, Benoit (October 1963). The Variation of Certain Speculative Prices. The Journal of Business, Volume 36, No. 4, pp. 394-419]

This claim aids in identifying not only potential returns from options trading, but also of risks involved. The magnitude of price movement in the direct and immediate past is a predictor of how it is likely to behave in the future (although direction of movement cannot be known). Traders seeking low risk should therefore select options on underlyings with low historical volatility; and those willing to behave more speculatively may seek out options whose underlying has been much higher in historical volatility. In both cases, the most recent data are going to yield the most reliable analysis.

Because historical volatility is easily identified, it is a sensible starting point for articulating cyclical volatility. Few underlying issues are consistent in their historical price behavior. Therefore, the most recent trends are most useful. This claim that large or small changes are likely to indicate future movement, should be apparent once it is expressed. Even so, options traders are not always likely to apply this observation in selecting one option trade over the other. It might not even be used to select a strategy at any moment. When a favorite underlying has exhibited low volatility, this may be sed to select a list of strategies that are appropriate, given the trader’s risk tolerance. Likewise, when volatility has been high recently, it may indicate a completely different list of possible strategies. When volatility changes dramatically, it could also be used to signal the timing of entering no new trades or closing current trades. This risk analysis is perhaps among the most useful traders can use to manage market risks for options.

This explains use of the term “cyclical” in describing volatility. It is the most recent trend toward higher or lower volatility in the underlying. This directly affects option premium values, but because no form of volatility provides information about the direction of changes, it is limited to an understanding of the changes in risk and return. This is extremely valuable information, and it adds context to the observation of historical volatility levels. It makes the analysis not only sensitive to time, but also to how risks change as volatility adjusts.

Can the same cyclical approach be used to estimate implied volatility? To a degree it can, but because IV is always an assumption, the most sensible method for cyclical analysis would be to base future estimates on historical option pricing. In other words, the degree of risk in implied volatility may be based on price changes in the option itself. This is a form of option-based historical volatility. It is complicated, however, because time decay distorts and determines volatility, notably as expiration approaches.

The sensible determination of cyclical implied volatility would have to be based on past option volatility as specific moments. For example, selecting times to expiration (4, 3, or 2 weeks, for example), how has one option behaved compared to another. Applying identical assumptions of implied volatility, how accurate have these been in understanding premium movement? This becomes difficult to apply, because – as options traders know – the behavior of one option is different than that of another, even given the same circumstances and timing. For these reasons, a starting point of cyclical analysis is more sensible based on the underlying in the moment. A comparison between several underlying issues and the historical volatility of each will indicate the recent and current volatility (risk) levels and help traders to improve their selection of underlying securities and option strategies.

The intention in implied volatility has always been to accurately estimate future volatility levels, but the reliance on this estimate is flawed and not as reliable as traders would wish. However, when the analysis is based on cyclical historical volatility of the underlying, risks are better understood.  It makes sense when recalling the nature of options. They are called derivatives because they are derived from price movement in the underlying (historical volatility). Overlaying the cyclical component improves the application of volatility in selection of both the underlying and the option strategy.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

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