Flaws in Implied Volatility

Implied volatility is an estimate based on current levels of price and  moneyness, but these matters change every day.

Timing of option trades is likely to be improved by relying more on price-related and momentum signals, and not aimed at the effort to estimate future volatility. Today’s volatility tells traders what they need to know to time their decisions profitably. Consideration such as moneyness and proximity matter. When the current price per share is close to the option strike, timing is likely to be improved, whether entering or exiting. Another form of proximity is related to price in comparison to resistance or support. Most reversal signals are most reliable when they occur right at these trading range borders. If price gaps through resistance or support, and reversal signals appear, this is exceptionally strong timing for options trades.

Options traders often prefer implied volatility (IV) to time trades, but this rarely makes sense. IV has value to some extent, but it is an estimate only and is based on what you see today, not on what is likely to happen in coming days or weeks. Traditionally, traders like to enter long trades when IV is low and exit when it increases; or to enter short trades when IV is high and exit when it declines. However, analysis reveals that this is equally effective when applying the analysis to historical volatility, which is more reliable because it is factual and not an estimate.

Support for relying on IV comes largely from academia, where IV is tied directly to the efficient market. However, this also is flawed. The efficient market hypothesis (EMH) states correctly that prices efficiently take news into the price immediately. However, no distinction is made between true news and rumor, so false information has the same effect on price as true information. This efficiency also fails to identify how far a stock price should move. Anyone who has observed market reaction to earnings surprises sees a big price move, often exaggerated. In comes sessions, the price retraces to previous level.

This is not efficient.

That’s the entire point. EMH is poorly named because it implies that markets are efficient, when in fact only discounting of all information (true and false) is efficient. When options traders rely on IV and point to “efficiency” as justification, they are relying on a signal containing no true value.

Proponents of IV claim that (s) the market is efficient, and this is reflected in IV and (b) this fact allows traders to accurately predict the future.

However, the efficiency of price behavior based on information often gives off a false signal, so that IV itself reflects the inefficient interpretation of price. Traders know that short-term price behavior is inefficient and chaotic, so that IV – as a direct factor of this assumption – is not reliable for timing trades.

A related problem is the significant variance in IV based on moneyness of different strikes and time to expiration. Informed short traders know that time is an ally, and time decay is a primary source for profits. However, this is easily based on historical volatility rather than on the less reliable implied volatility. A debate about which form affects option premium is unsettled; but traders will discover that relying on historical volatility provides reliable timing information to exploit volatility.

The problems with IV are evident in the wide variances of levels based on moneyness and time to expiration. This tendency to vary is called the volatility surface, and it relies on current option premium levels as the source for future movement; in truth, those premium levels are not the source, but the result of historical volatility and moneyness. A detailed study of stock and option prices concluded that there is no consistent evidence that IV determines or affects future option value. [1]

IV is not accurate or reliable, despite common belief that it is both. Another study pointed out that IV is not a valuable indicator at all:

In theory, the implied volatility is the market’s well-informed prediction of future volatility. In practice, however, the arbitrage trading that is supposed to force option prices into conformance with the market’s volatility expectations may be very hard to execute. It will also be less profitable and entail more risk than simple market making that maximizes order flow and earns profits from the bid-ask spread. [2]

Although there are five factors going into the Black Scholes pricing model (BSM), only volatility is unknown and must be estimated; and this is where inaccuracy comes into play, making the pricing model deeply flawed.

The intent of IV is to identify current volatility and predict future volatility, but it cannot predict the future. Volatility itself (defined as “risk”) cannot be quantified for the future in any case, so any assumption by traders that IV is a reliable test of future price movement, is simply untrue. This is easily demonstrated by another factor: Volatility reveals the likely movement of an option’s premium, but not the direction. Options traders are naturally interested in figuring out where the price will move, but volatility articulates the range of price movement and not the direction.
 

A final flaw is that as expiration approaches, volatility will become as uncertain as price of the underlying. This “volatility collapse” makes IV unreliable in the final week before expiration. But this is the week where many traders focus. If a trader is active in the final week of the option’s term, but also relies on IV, there is no certainty whatsoever of profitable outcome. A simple observation of moneyness and proximity to resistance or support makes more sense.

The use of IV can be compared to reliance on forward P/E. This is an estimate of future P/E but contains assumptions, often based on wishful thinking or flawed assumptions. It may also be compared to the accounting reliance on pro forma financial statements, estimates of future revenue, costs and net profit. This may be based on detailed forecasting that sounds scientific but, in fact, cannot be called accurate. If traders know that estimates of future P/E or net profits are unreliable, why depend on IV to estimate future volatility of options?