Options Trading Strategies – Improper Use of Historical Volatility and Implied Volatility Crossovers
BusinessNot all volatilities are constructed in the same way. Differentiating between historical volatility and implied volatility is critical for retail traders to learn options trading by focusing on what is material to theoretically price forward option spreads.
Historical volatility (HV) measures the past price movements of the underlying asset and records the actual or realized volatility of the asset. The best known type of HV is statistical volatility, which calculates the performance of the underlying assets over a finite but adjustable number of days. Let me explain what “finite but adjustable” means. You can vary the number of days to measure statistical volatility: for example, 5-10-50-200 days, this is how time-based moving averages and momentum/oscillator studies are constructed. However, this is not the case for implied volatility.
Implied volatility measures expected values by repeatedly refining estimates of supply and demand. These estimates are based on the expectations of buyers and sellers. Buyers and sellers (over 85% of floor traded volume is driven by institutions, floor traders and market makers) behind the bid and ask values, who change their estimates throughout the day as new information Whether it’s macroeconomic news or micro-economic data that affects the underlying product is available. What is estimated is the future fluctuation of the underlying asset with certain assumptions built into changes in the underlying information. That refinement of supply and demand estimates must be completed within time-limited options expiration periods. This is why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, to “build” a time frame that gives you faster or slower cross indicators.
Why point out the incorrect use of historical volatility and implied volatility crossovers? It is to warn you against misusing HV-IV crosses, which is not a reliable trading signal. Remember, for a given expiration month, there can only be one volatility during that specific period. The implied volatility must move out from where it is currently trading to converge to zero on the expiry date. Implied volatility (either IV for ITM, ATM, or OTM strikes) must return to zero at expiration; but, the price can go anywhere (up, down or stay flat).
Continually selling “overvalued” options and buying “undervalued” would eventually cause the implied volatility of each non-zero bid option to line up exactly. Which means that the phenomenon of IV’s “smiley” skew disappears, as IV becomes perfectly flat. This hardly happens, especially in highly liquid products. Take, for example, the SPY, a broad-based index; Gold, GLD – SPDR’s Equity ETF in a fast market like gold. With open interest in non-zero bid strikes running into the thousands and tens of thousands, do you really think a retail trader off the floor will be able to “beat the price” of the professional hedger on the floor? Unlikely. Calls and Puts on highly liquid products are like items in high supply inventory because there is high demand. This type of inventory does not have “wrong values” because floor traders have to make a daily living trading call and put options; they will refuse to risk mispricing overnight.
So what are the key considerations for banking to your advantage as a retailer?
- The percentage impact of IV on the extrinsic value of an option is much larger for ATM and OTM strikes, compared to ITM strikes that are loaded with intrinsic value but lack extrinsic value. Most retail options traders with an account size of USD $25-$50K (or less), gravitate towards ATM and OTM strikes for affordability reasons. The deeper the ITM, the wider the bid-ask spread becomes compared to the narrower bid-ask spread spreads in ATM or OTM strikes, making ITM strikes more expensive to operate.
- When you trade IVs, you are buying drop time for an increase in IV by one percentage point lower; or, selling time premium for a drop in IV to one percentage point above the theoretical market value price, which participants are willing to pay or sell. Depending on the market ranges for that day, price debit spreads are filled to 0.10-0.15 below the spread’s theoretical price. With credit spreads, increase the credit to sell the spread by 0.10-0.15 above the theoretical price of the spread. The price you pay next; or receiving above the theoretical price of a spread is to your advantage, based solely on price-yield implied volatility only. Remember, in theory, the price has been extended to fill the order for its forward value, never the other way around.
Where can I learn how to trade options with constant profit focused on implied volatility without historical volatility? Follow the link below titled “Consistent Results” to view a retail options trader portfolio model that excludes the use of HV and focuses on trading IV only.
I will cite these true historical facts to bolster the case for completely removing historical volatility from your negotiating process.
February 27, 2007: Widespread panic over major stock sell-off in China. If you were trading options on an index like FXI, which is the iShares product of the 25 largest and most liquid Chinese companies in China, although they are listed in the US; but they are based in China, you would have been affected. While you can argue that market events may recreate the Dow, Nasdaq and S&P ranges, how do you recreate the sky-high 59% and 39% VIX and VXN scenario?
January 22, 2008: The Fed cuts rates by 75 basis points ahead of the January 30 policy meeting, while the FOMC cuts another 50 basis points on the date of the meeting. If you were trading interest rate sensitive sectors using the options on a financial ETF or a bank index like the BKX; Or, the housing index like the HGX, would have been affected. And in the current near-zero rate environment, the FOMC, while still having a rate policy tool, cannot cut rates by the same number of basis points as before. What was a historic event cannot be repeated successively in the future, not until rates are raised again and then lowered again.
Question: How is history reconstructed? That is the story of the events that make up the Historical Volatility. The answer lies in the actual examples cited, as with any other historical event related to finance: history cannot be reconstructed. You may be able to mimic parts of HV but you can’t repeat it in its entirety. So, if you continue to use HV-IV crosses, you will be visually confused looking for “bad value” volatility patterns that you would like to see; but instead you will end up with a poor earnings performance. It makes more practical business sense to focus solely on IVs; Then, diversify volatility trading across multiple asset classes beyond stocks.
Where can I get more information about IV trading across multiple asset classes using just options, without having to own stocks? Please follow the link below (video based course), which uses IV Mean Reversion/Mean Repulsion and IV Forecast, as reliable methods for trading implied volatilities in broad-based equity indices, commodity ETFs, ETFs forex and emerging market ETFs.