What Volatility To Use? (07:06)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 7, No. 6 on March 26, 1998.

There are only two types of volatility – historical (also called actual or, sometimes, statistical) and implied. Historical tells us how fast the underlying security has been changing in price. Implied is the option market’s guess as to how fast the underlying will be changing in price during the life of the option. It’s easy to see that these might rightfully be completely different numbers. For example, take the case of a stock that is awaiting approval from the FDA for a new drug application. Often, such a stock will trade in a narrow range, so historic (actual) volatility is low, but the options will be quite inflated – indicating high implied volatility that reflects the expectation of a gap in the stock price when the FDA ruling is made.

Thus, the strategist is faced with the decision of whether to use historic or implied volatility in his analysis of a prospective position. But, to make things even more difficult, one might need to consider both of these volatilities in more detail. For example, when historic volatility is considered, one usually looks at the 10-day, 20- day, 50-day, and perhaps even 100-day or one-year historic volatility. These, too, can be extremely different numbers. Take $OEX, for example. The current historical volatility readings are:

These numbers are so disparate because of what has happened to $OEX prices in the last 100 days. Going back 100 trading days takes one back to late last year when prices were quite volatile and were bouncing around a lot. However, the current bull market has been very uniform, and that indicates a lessened actual volatility. Thus, the numbers get smaller and smaller as the look-back period is shortened.

In a similar manner, implied volatility is currently about 20% for $OEX options. However, looking at the chart of the $VIX Index (which is a chart of $OEX implied volatility) in the insert shows that it has been much higher in the last few months. An even longer look-back, though, would show that it has been much lower in past years.

So what is a strategist to do when he is trying to analyze a volatility trade position – what volatility out of this myriad of numbers should be used? Obviously, there is no way to say for sure – if there were, then all volatility traders would be millionaires. But some reasonable approaches can be taken.

First, do not assume that implied and historic volatility will be equal. In fact, a subscriber recently pointed out that, if one assumes that historic and implied volatility are the same now, and are going to be the same in the future, then straddle buying should produce a profit over 80% of the time. I have bought a lot of straddles in my life, and have analyzed a lot more, and I can tell you that 80% is too high of a general probability estimate for straddle buys – obviously, individual cases can have probabilities like that, but not all.

In other words, just because implied and historical volatility happen to be equal to each other, that does not mean that a good straddle buy is at hand. Consider the case of a stock that has just announced bad earnings. It falls dramatically – inflating historic volatility – and the options are quite expensive because of the sudden change in the company’s fortunes. It usually turns out that both actual and implied volatility decrease over time after the sudden drop in stock price, as reality settles in. Thus, it would not be a good assumption that it’s okay to buy straddles right after the crash, just because implied and historical volatility are equal at that time. The same logic would apply after a general stock market crash as well.

Rather, one should make assumptions about volatility, based separately on where implied and historical volatility have been in the past. With respect to historic volatility, look at the averages, such as those shown for $OEX in the left-hand column. For example, for $OEX, one would use the lower range of the historic volatility estimates – between 8 and 13% – if he were considering a straddle buy or other “long” option position. However, if he were thinking of establishing a position that had naked options or was prone to losses if $OEX were volatile, then he should analyze the position as if $OEX were going to trade in the higher end of its historic range – at 15% or maybe even more.

With respect to implied volatility, one should have some idea of whether the current reading is high or low. If it’s low, then option buying strategies should be considered, for if implied volatility were to return to the middle of its range, then that would benefit positions which contain long options. If implied volatility is high, then – after ascertaining that there isn’t a fundamental reason why that should be true (takeover rumor, for example) – option selling strategies can be considered.

This article was originally published in The Option Strategist Newsletter Volume 7, No. 6 on March 26, 1998.