Monday, November 16, 2009

Overcoming the Gap Factor

In Historical Volatility: The Gap Factor, I explored the affect that large gaps in the underlying price can have on historical volatility. Basically, these gaps artificially skew historical volatility too high such that it overstates true realized volatility for as long as the gap remains in the calculation. Take a look again at the graphic displayed in the original post (click any image to enlarge):
[Source: Livevol Pro]

Notice how the gaps that occurred during the last four earning announcements (the blue "E") caused an immediate surge in historical volatility. Once these gap days fall out of the equation (30 days later), historical volatility usually tanks, bringing it more in line with reality. This gap factor presents an interesting dilemma for those trying to use IV-HV analysis. That is to say, it is difficult to get an accurate read on whether IV is trading too high or too low compared to HV if indeed historical volatility is skewed extremely high.

The logical fix is to use a historical volatility reading that doesn't include the gap in its calculation This can be done by assessing a shorter term reading. For example, if the 30 day HV is skewed because of the gap, try looking at a 20 day or 10 day HV reading. If the gap occurred at least 11 or 21 days ago, it shouldn't be included in one or both of these calculations. Consider the following price and volatility chart on AMZN.
With HV30 around 75% and IV30 around 40%, the options seem cheap. However, is this a fair comparison? The answer is no. HV30 is skewed because of the monster earnings gap, it would be wise to look at a shorter HV measurement. We could try HV20, but since the gap took place within the last 20 trading days, HV20 will also be skewed. How about HV10? Let's take a look.
Now that the gap is out of the calculation you can see how low realized volatility truly is. Currently HV 10 is sitting around 25% or so,much lower than the 75% originally stated by HV30. With the HV10 light shed on things, options don't seem so cheap after all.

Some may argue 10 day historical volatility can be quite erratic since it encompasses such a small data set. As for myself, I'd rather deal with a more erratic reading than use one that is skewed way too high.

For other posts touching on historical volatility, readers are encouraged to read:


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