LEVEL:Â INTERMEDIATE
Monitoring Volatility
Investors need to monitor volatility to understand the sentiment within a financial market. When markets are volatile, investors should understand how their portfolio will be affected, or how this should affect their decision to initiate a new position. Volatility generally measures both fear and greed within financial markets.
Implied volatility and historical volatility can fluctuate above and below each other. Generally, implied volatility is higher than historical volatility, which is why the majority of long option trades expire worthless.
Historical volatility and implied volatility are similar components that are used to trade the financial markets. While historical volatility is used mainly to gauge the risks associated with a portfolio, implied volatilities are considered market inputs, which alter the values of options on financial instruments.
Volatility
Volatility is a term used to describe multiple facets of the capital markets. Volatility is referred to as past price action as well as potential future price movements, which in turn determine the implied volatility that influences option prices more than any other factor.
Volatility is altered by external events such as monetary policy, economic data, and earnings announcements, as well as by changes in sentiment as investors become more fearful or greedier.
Past price action is also used to speculate on future price action as well as future implied volatility. Analysts will use implied volatility to create a model which generates a value for option related financial instruments.
Historical Volatility
Volatility that is viewed in the rear-view mirror is referred to as historical volatility. Past price action is used for a number of specific risk calculations, which include value at risk (VAR). This examines the loss associated with a specific volatility (usually by two standard deviations). By looking at the historical volatility of assets within a portfolio, an analyst can calculate the value at risk of the portfolio. The volatility of multiple assets along with the correlation of the assets can assist in determining the worst-case outcome for the portfolio.
Historical volatility is a measure of the standard deviation over time. This figure is used to create an annualized move on a percent basis. Risk calculations base many of their assumptions on historical price action, given that it is a benchmark to gauge future price action.
Volatility is relevant within the financial community as it is one of the key components for determining risk calculations as well as the main input in valuing options.
Historical volatility is formulated by comparing the standard deviation that a financial instrument’s returns offers, and multiplying that number by the square root of time. This formula will create a decimal which can be reflected as a percent, which describes a move over an annualized basis.
Implied Volatility
Implied volatility is the potential theoretical annualized movement of a security in percent format. Implied volatility is the amount traders believe the market will move and is the key input into most option pricing models.
Implied volatility is traded actively in the form of option structures, such as calls, puts, straddles or strangles, or in the form of ETFs that focus on specific volatility indexes. Implied volatility is a market-based measurement and therefore it fluctuates with market sentiment.
The most widely known and traded benchmark for volatility is the VIX volatility index, created by the Chicago Board of Options. The VIX measures the implied volatility of the S&P 500 index by tracking the strike prices of at the money S&P 500 options. On the Chicago Board of Options, the VIX trades as a future contract as well as an option on a futures contract.
This VIX is also traded in the form of an exchange traded fund and exchange traded notes. For more on Volatilty ETFs, see this article.