Volatility And Value
Three kinds of volatility concern option traders: the future volatility of the underlying, the historical volatility of the underlying, and the implied volatility of the option. The most important of these is the future volatility of the underlying, but this is also the one that is most difficult to estimate.
I say “kinds of volatility” because in each case there are various ways to measure the volatility. For instance, the historical volatility can be measured using the last 100 days of data, as we do for calculations on this site, the last 50 days, the last 20 days, etc. And “volatility” can be measured in various ways, although if you use the standard models you must use one of the standard calculations that measure the standard deviation of the percentage changes in the underlying.
Likewise, the future volatility can mean the future volatility over the next 10 or 20 days, the next 100 days, the days to expiration, and so on. Again, the standard models assume that volatility is constant and in this case the future volatility that counts is the volatility between now and expiration.
The most unambiguous of the three kinds of volatility is the implied volatility of the option, but even this is subject to some fuzziness. The price of the option and the price of the underlying determine the implied volatility of the option, and these prices may not have occurred simultaneously, although if you use closing prices and the closing rotation price of the option you are probably looking at a fairly accurate picture of simultaneity.
Historical volatilities and implied volatilities are used by various traders in various ways to estimate the future volatility of the underlying, the one that counts most. The 100-day historical volatility may not accurately estimate the volatility of the underlying between now and expiration. So you might want to use a shorter-term historical volatility. Or you might want to give some weight to the implied volatility of the option. And so on.
The implied volatility of an option is considered by some to be the market’s estimate of the volatility of the underlying between now and expiration. But the implied volatilities of various options on an underlying are usually different. And they can’t all be correct, because the future volatility of the underlying between now and expiration is going to be one number, although we don’t yet know what that number will be. So if implied volatilities of options on the same underlying are different, a logical inconsistency exists in the market and you should be able to exploit it.
This is just the first of a series of commentaries I will write on volatility, which is in some ways the most important thing to understand about options. In a way that we will see later, in the Black-Scholes market-neutral world, it is the actual volatility of the underlying during the time you hold an option that determines whether you can earn money by trading that option. And to trade options really effectively, you must understand volatility.