Friday, November 6, 2009

Historical Volatility: The Gap Factor

If you missed last weeks Volatility Quiz, you can check it out here.

Similar to question number two, quiz question three also tested your ability to read a volatility chart to ascertain the relative value of option prices. Roughly 90% of you answered correctly stating that options seemed under priced. Take another gander at the question and corresponding volatility chart:
[Source: Livevol Pro]

HV20 has recently surged up to 70%, while IV30 has fallen to about 35%. If you were of the opinion that the stock was going to continue to exhibit 70% volatility, then options are a steal at 35%. We may consider initiating a long volatility strategy via a straddle or calendar spread. In addition to being "cheap" compared to HV, implied volatility also seems cheap relative to itself as it's sitting at its lowest levels in the last 6 months.

One notable issue with using historical volatility in an effort to forecast future volatility is the fact that HV can be artificially skewed by large gaps in the stock price. More times than not these gaps are relatively short term events, such as earnings announcements, not indicative of the day to day volatility actually realized by the stock. These large moves can skew the HV reading for as long as they remain in the calculation. Once this gap, which we can consider an outlier when compared to the normal day to day moves, falls out of the calculation HV tends to revert back down to more "realistic" levels. Consider the following chart displaying 20 day historical volatility of First Solar Inc (FSLR).
Notice the sharp increase in HV when each earnings gap enters the equation (the blue "E" icon). 21 days later as the gap falls out of the equation (the red "Out"), notice the sharp decrease in HV as it reverts back to a more accurate reflection of the day to day volatility.

For the chart displayed in quiz question #3, you can see the HV 20 was skewed artificially high to 70% due to an earnings gap. Truth is 70% is probably NOT how volatile the stock will be going forward. Make sure you keep this "gap factor" in mind anytime you're assessing volatility charts.

Next time I'll explore a few ideas for handling this artificial skew.

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