Volatility

Traders and investors use different sets of tools when approaching markets. Some are
fundamentalists, pouring through balance sheets, supply and demand data, and other macro and
microeconomic information to predict the future prices of assets. Others have a strictly technical
approach to markets, following trends and the path of least resistance of prices. Still, others
combine the two to look for opportunities where fundamental and technical analysis merge to
improve the chances of success.

 The past is history; the present is all that matters for traders and investors
 Historical volatility is a map of the past price variance for asset prices
 Implied volatility is a real-time sentiment indicator
 The primary variable determining put and call option prices
 The three critical factors implied volatility reveals

Yogi Berra, the hall of fame catcher and armchair philosopher, once said, “The future ain’t what it
used to be.” All market participants have the same goal, to increase their nest eggs. Projecting the
future is the route to achieve their goal.
Implied volatility is a tool that all market participants need to embrace as it is a real-time indicator of
market sentiment.

The past is history; the present is all that matters for traders and investors
History depends on interpretation. When it comes to markets, Napoleon Bonaparte may have said it
best, “history is a set of lies agreed upon.” An asset’s price moved higher or lower in the past
because of a collection of variables viewed through a prism that leads to a collective conclusion that
has broad acceptance but may not be accurate. Taking a risk-based position on an inaccurate
conclusion could lead to mistakes and losses.
When we consider buying or selling any asset, all that matters is the present. The current price of
any asset is always the correct price because it is the level a seller is willing to accept and a buyer is
willing to pay in a transparent environment, the market.

Historical volatility is a map of the past price variance for asset prices
Historical volatility is an objective statistical tool that defines the price variance of the past. Any
disclosure document tells us that past performance is no guaranty of future performance. We must
view historical volatility precisely the same way, with more than a grain of salt.
Historical volatility is a guide, but remember what Yogi said, “the future ain’t what it used to be!”

Equation for volatility

simple explanation of the complicated formula comes in seven easy steps:

1. Collect the historical prices for the asset

2. Compute the expected price (mean) of the historical prices.
3. Work out the difference between the average price and each price in the series.
4. Square the differences from the previous step.
5. Determine the sum of the squared differences.
6. Divide the differences by the total number of prices (find variance).
7. Compute the square root of the variance computed in the previous step.

Implied volatility is a real-time sentiment indicator

While we can calculate historical volatility from historical data, implied volatility is a different story.
Implied volatility is the expected or projected volatility or price variance of an asset over time.
We back into calculating implied volatility using an options pricing model. We can establish an
implied volatility reading by entering the option value into the Black-Scholes options pricing formula
or other formulas that determine options prices. If we have a put or call options price, we can solve
for the implied volatility level. The Black-Scholes formula in mathematical notation is:
The primary variable determining put and call option prices

There are no option prices without implied volatility as it is the critical variable that determines put
and call option values. Yogi also said, “You can observe a lot by watching.” The current implied
volatility level is the market’s consensus perception of what volatility or price variance will be during
the life of the put or call option. Observing and watching reveals the constant changes in implied
volatility levels, which can be highly volatile over time. Option traders call an option’s sensitivity to
changes in implied volatility Vega , which measures the change in an option price for a one-point
change in implied volatility . Implied volatility is constantly changing. Yogi had another great saying,
“If the world were perfect, it wouldn’t be,” which rings true for implied volatility which can change in
the blink of an eye. Option traders pay lots of attention to their Vega risk as the volatility of implied
volatility can be…highly volatile! How’s that for a tongue twister?

The three critical factors implied volatility reveals

Implied volatility is a valuable tool for all traders and investors for three significant reasons:

 It is a real-time indicator of the market’s perception of the future price range of an asset.
 It can change suddenly, and changes often occur before the price of an asset reacts, making
implied volatility a leading indicator.
 Implied volatility reflects the wisdom of the crowd, and crowds tend to make better decisions
than individuals. Moreover, it is reading that reflects the present, not the past, and is a
constantly changing measure of consensus forecasts for the future.