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Really state of the art option work is placing less and less emphasis on
historical vol. In fact if you look at the many of the top traders and
houses they spend their money attempting to model future vol. If you could
generate a good estimate of future vol..you would have a veritable gold
mine.
Here is the concern. Historical has always been a poor measure of implied
and also a poor measure of actual. Actual vol is what you would really like
to know. Nobody has, to the best of my knowledge, created a great system
for generating guess at actual and future vol.
A lot of folks trumpet the relationship between implied and historical and
quote a lot about "mean reversion" of vol. Anyone who does any type of
moving average work knows that mean reversion WILL ALWAYS EXIST, but so
what. If the historical was 10 and the implied is 12, eventually the
historical will move towards 12 with enough observations. So the concept of
mean reversion isn't, IMHO, nearly as valuable as one might expect. Now
there are some natural tendencies. 8% - 9% has been low for the S & P and
30% has traditionally been high. Again so what. If vol got down to 8% you
would probably find the whole world wanting to buy it, which means it
wouldn't stay at 8% for long.
Implied is a collection of tangible data and intangible views.
The issue in ANY OPTION TRADE is NeVER the relationship between IMPLIED and
HISTORICAL, although too many people assume it. The issue in an option
trade is the relation between IMPLIED and ACTUAL. Now if you draw the
assumption the future vol has a relationship to historical then historical
is of some importance. In my view historical, except at extremes, is
unimportant. S & P vol is currently in the mid 20's(immplied). Is it high
or low?
This is where the "art and science of option trading come into
play....especially for short term option(for longer term options or for ITM
options vol plays a much smaller role in the overall decision).
When a skilled option trader says vol is high....they are assuming it will
be lower in the future. To say vol is high versus historical is irrelevant,
UNLESS YOU BELIEVE THAT THE HISTORICAL LEVEL IS FACTOR IN FUTURE VOL.
If you look at the American equity market for the past few years IMPLIED has
been too low. What does that mean..it means that the buyers did better than
the sellers of option. If you thought implied was too low..you are
predicting higher vol down the road and you would employ trades that benefit
from increases in vol.
To the short term option trader vol can often be more important than
direction.
If you right about vol and wrong about direction you may find your trade
won't, in fact, lose money.
If you are wrong about vol and correct about direction you might be shocked
to discover that your trade doesn't make money.
This is what drives a great many short term traders out of options in
general.
They find they are right about a move in the underlying...they buy/selll and
option to fit the move and they lose money. They then draw the conclusion
that another market, usually the cash or the surrogate(futures) is
superior. In fact to the person who doesn't understand vol the other market
is superior.
To the person who understands vol and has a good handle on the character of
the underlying instrument, options are vastly superior.
As a general rule and as someone who trades and teaches options I would urge
anyone getting into options to READ and UNDERSTAND one of the better option
books. My two favorites, for the short term trader, are Shelly Natenburg's
and Gary Gastinaeu's. If those book frighten or intimidate you you ought to
consider NOT trading on very short term basis. I say that remembering that
a part of personal income is based on option trading volume.
Desmond Sutherland wrote:
> Yes, implied volatility is more easily determined than historical
> volatility. But it depends on your assumptions for the two other
> variables in Black-Scholes, i.e the dividend yield [stocks only] and the
> interest rate. These other two variables will fluctuate in a [narrow?]
> range.
>
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