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Types of Volatility


Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.

Historical volatility

The best known form of volatility is based on underlying price behavior. Historical volatility has certainty, because it reflects price activity in the recent past, with no estimates of the future. Options are derived from the underlying price activity, and option premium is derived from historical volatility. This does not tell us what will happen next, but it does provide a means for comparing risk (volatility is risk, in fact). In looking at historical volatility for several underlying issues, it becomes natural and easy to compare risks from one to the other.
 

The historical record of volatility allows traders to estimate the likely risk level, based on possible price movement. The longer the period analyzed, the more reliable this will become. If an underlying his displayed low historical volatility over many years, it is less likely that high implied volatility of the option will follow, at least when comparted to an underlying with much higher historical volatility.


It can be calculated using several variables. The most reliable are (a) the period being studied and (b) the interval between price movement and change (daily, weekly, monthly, for example). The best-known and most often used are one year and daily price changes but using a smaller number of daily sessions also focuses current volatility on the most recent information.


Despite widespread popularity of implied volatility, the fact is that the underlying historical volatility is probably the most reliable measurement of risk in both the underlying and its options.

 

Implied volatility

A popular but somewhat uncertain test is implied volatility of the option. This calculation is nothing like that for historical volatility. It is strictly an estimate of future volatility, based on some assumptions (which themselves are subject to interpretation). Many options traders swear by implied volatility but questioning why this is so makes sense. Would the same trader rely on underlying price change based on recent historical volatility? Probably not. It doesn’t make any sense. The same logic can be used to question implied volatility and its value.
 

A good question to ask is which volatility is used by the market. Few traders not using options will ever try to estimate implied volatility, because that belongs only to the options market. This does not make it reliable; in fact, can anyone say that all options traders are using the same pricing model? No. In fact, there are many pricing models, and even those using the same one (i.e., Black Scholes) are probably not using the same assumptions to determine volatility. Implied volatility is subject to a lot of interpretation and it is most loved among academics, but much less among traders. That may be the bottom line and the most revealing fact of all.
 

Future volatility

This is the volatility that every trader dreams of understanding, by whatever name it is given. This is the future distribution of prices for the underlying. No one who has followed the broader markets will be able to claim that they know what future volatility will be. In fact, one characteristic of the market is that it constantly surprises all its players, and no one can accurately predict what future volatility will be, not to mention the direction of price movement.


If you can guess at the right probability, you can accurately predict future volatility. But probability is just as elusive as all other market factors, and no one can know what will happen tomorrow, next month, or next year. It is equally impossible to know ahead of time what factors will cause markets to rise or fall. There are so many, including those not yet known or understood by anyone.

 

Forecast volatility

Every market has its share of “experts,” people or companies that confidently predict volatility in coming days, weeks or months. They cite numerous justification for their opinions, but it is unlikely that anyone has gotten rich investing or trading based on estimates of forecast volatility.
 

Ironically, many forecasters claim that they rely on the fundamentals, but forecast volatility is as technical a signal as anyone can find. It is all guesswork, and the only certainty available is that time value declines as expiration approaches, and the day after expiration, every option is worth zero. This knowledge is known in advance by every trader, but with options, the idea is to gain in-the-money value (for long options) despite the knowledge of how time works against the long position (and in favor of the short position). Forecast volatility for options is no more reliable than for the underlying, because these two are related. As the underlying behaves, so too will the option (given the added variables of time decay and expiration).

 

Seasonal volatility

A final version may be called seasonal volatility. For options on futures contracts, this is well understood for agricultural contracts, but for equity options, is there a seasonal version? There is, in fact. For example, in a political year, the season approaching election day has everything to do with risk. Which candidate will win, and how will that affect overall markets and options? The 2016 election say dramatic and sharp increases in equity value right after the election, contrary to dire predictions offered by many “experts” on market  matters. Will 2020 have a similar cause and effect based on which candidate wins?
 

The same observation can be applied to off-year politics, to future volatility guesswork, and even to the weather. The important factor to keep in mind is that volatility in most forms is largely a matter of guesswork, and at times the “educated” guess may be just as dubious as the arbitrary or uneducated guess.


This is the problem with volatility. All traders, including options traders, constantly seek a reliable method for improving timing and reducing risk. If that were possible, every trader could become rich because beating the odds is an intrinsic part of the options world. But it is not actually possible for anyone. Volatility could be thought of as another word for the term “uncertainty.”

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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