Volatility a key concept of Option Trading
In the world of trading and finance, volatility is a key concept that every trader should be familiar with.
It provides insights into the expected price fluctuations of the instrument you trade.
In this post, we’ll delve into the differences between historical volatility and implied volatility, explain how the VIX is calculated, and touch upon the concept of a volatility smile.
Historical Volatility vs. Implied Volatility
Historical Volatility (HV)
- Definition: Historical Volatility gauges the fluctuations of an underlying security’s price in the past.
- Importance: It’s a factual, statistical measure, and gives traders an understanding of how volatile a security has been over a specified timeframe. By studying HV, investors can compare current volatility to past volatility to identify any unusual activity.
Implied Volatility (IV)
- Definition: IV, in contrast, projects future volatility and is derived from an option’s current price.
- Importance: It’s a forward-looking metric. Investors and traders use IV to estimate how volatile a stock (or index) will be over the life of the option. A sudden change in IV can indicate changing market expectations
The chart above is an example of the hiostoric volatility of the Nifty
At – https://charts.vtrender.com/hv-stock-chart/NIFTY, you can check the volatility and plot it with any parameter of your choice. The key is to undertand how the instrument has behaved in the past
The chart above is an example of an Implied Volatility . This works from the options current price and projects future volatility over the life of the option. The key term to undertand here is the “life of the option”. The IV takes often a shape of a smile or has a skew on either the call or the put side. We will talk about this a little down in this same post
How is the VIX Calculated?
The VIX, or the Volatility Index, represents the market’s expectation of 30-day forward-looking volatility. It’s derived from the prices of the index options
When calculating the VIX, the goal is always to capture a 30-day expected volatility. As a result, the VIX typically uses two consecutive expiration series of options. Focus on the fast that it calculates 30 days ahead.
Here’s a general breakdown of how the VIX transitions from one month’s options to the next:
Start of the Month: At the beginning of a month, the VIX primarily focuses on options that expire in approximately one month. For instance, if today is the 1st of August, the VIX would predominantly consider options expiring in late August or early September to capture the 30-day outlook.
As the Month Progresses: As days go by, the weightage given to the current month’s options decreases, and the weightage given to the next month’s options increases. This is because the time to expiration for the current month’s options keeps decreasing, moving away from that 30-day window.
Transition: The transition is continuous. As each day passes, the VIX will incrementally decrease its reliance on the current month’s options and increase its reliance on the next month’s options.
After Monthly Expiration: Once the options for the current month expire, the VIX fully relies on the next month’s options to estimate the 30-day expected volatility.
To achieve a constant 30-day maturity, the VIX index uses a blend of prices from two expiration cycles, interpolating between the two so that the resulting VIX value always represents a 30-day expected volatility.
It’s worth noting that with the introduction of weekly options, the VIX calculations can become more nuanced, but the principle remains the same: always capturing a 30-day snapshot of expected
Introduction of Weekly Options
With the advent of weekly options, the number of expiration cycles available at any given time increased.
This means that instead of just having monthly expirations, there are now options expiring nearly every week, providing a richer set of data to calculate expected volatility.
Traders need to be aware of these intricacies to effectively use the VIX in their decision-making process.
How Can Traders Adjust?
Awareness of Market Dynamics: With the VIX now having the potential to be more responsive due to weekly options, traders should be even more attuned to market events that might affect short-term volatility.
Understanding the VIX Composition: If traders are using the VIX as part of their trading strategies, understanding which expirations are heavily influencing the VIX at any given time can provide insights into market sentiment.
Weekly Vix : Traders need to know the Vix for the current weekly settlement not the whole 30 day program. This can prepare them better for an unexpected move in expected volatility.
The Option tables at Vtrender work with the weekly Vix for the selected weekly cycle. We also compute a range of trade based on the Vix .
The option tables are at – https://charts.vtrender.com/options-table
The computation of range based on the vix readings is at – https://www.vtrender.com/vix-nifty-range-explained/
You can also plot the Vix in MarketProfile by using this link – https://charts.vtrender.com/market-profile?symbol=INDIAVIX_SPT
Reading the IV Smile:
The implied volatility (IV) smile is an intriguing phenomenon in the options market. When you plot the implied volatility against different strike prices of options, you may notice that the IV tends to be higher for deep in-the-money (ITM) and deep out-of-the-money (OTM) options compared to at-the-money (ATM) options, forming a “smile” pattern. Here’s a deeper dive into understanding the IV smile and what it can tell you
At-the-Money (ATM) Options: These options have strike prices that are very close to the current market price of the underlying asset. They generally have the lowest implied volatility because their price movements are more predictable.
Out-of-the-Money (OTM) Options: As you move away from the ATM strike towards higher (for calls) or lower (for puts) strikes, the implied volatility often increases. This is where the upward curve of the smile begins to form.
Deep Out-of-the-Money (OTM) Options: The further out you go, the more pronounced the increase in implied volatility. This is because these options are more sensitive to large price movements in the underlying asset. Even a small change in the asset’s price can dramatically change the probability of these options ending in-the-money.
Why is Volatility Priced Higher Away from ATM?
Several factors contribute to the higher implied volatility for deep ITM and OTM options:
Demand and Supply Dynamics: Traders often use OTM options as a form of cheap insurance. For instance, portfolio managers might buy OTM put options to protect against drastic market downturns. This increased demand can drive up the option premiums and, by extension, the implied volatility.
Leverage Effect: Most traders use OTM options to drop margins required for spreads. For example if you want to sell a naked ATM option the exchange will charge a full margin for it, but buying a deep OTM same direction option can decrease your margin requirements drastically.
Market Fears and Asymmetry: Investors often fear rapid market declines more than they anticipate quick market rises. As a result, there can be more demand for OTM put options (as a form of protection), causing their implied volatility to be higher compared to equivalent OTM call options.
What Information is the Market Conveying?
The IV smile provides insights into market sentiments and expectations:
Expectation of Extreme Movements: A pronounced IV smile suggests that the market is pricing in a higher likelihood of extreme price movements. A flatter smile is more about a range bound behavior.
Skewness: If the IV smile is skewed more to one side (either puts or calls), it reflects the market’s collective expectation about the direction of future price movements. For instance, a steeper curve on the put side (known as a “skew”) might indicate heightened fears of a market drop.
Historical Events: The IV smile can also be influenced by past market events. If traders have witnessed sudden large market drops in the recent past, they might demand more OTM put options as protection, thereby influencing the shape of the IV smile.
In conclusion, the IV smile is a graphical representation of market fears, expectations, and potential future price behaviors. By understanding and interpreting it, traders can gain insights into market sentiments and better anticipate potential market moves.
A Real-world Scenario:
Using real-world data can elucidate these concepts. Let’s consider the Nifty index:
Context: With the Nifty standing at 19500, a VIX of 10.5 suggests that market participants anticipate a fairly stable period ahead for the index.
IV Shifts: Now, if the implied volatility of at-the-money (ATM) options drastically shifts from 28 on Thursday to 11 on Friday, it signals a marked change in near-term market expectations. Such a significant drop might be attributed to the fact that the new series may not have the same volatility as the previous one.
Conclusion
Volatility, whether historical or implied, provides crucial insights for traders and investors.
By understanding these metrics and tools like the VIX, one can make more informed decisions in the dynamic world of trading.
As always, it’s essential to stay updated with market news and continuously educate oneself to navigate the complexities of financial markets effectively.
Happy trading