Tuesday, November 3, 2009

The Tempest and Volatility Analysis

The second quiz question tested your ability to perform IV-HV analysis to ascertain whether options seemed cheap or expensive.

83% of you nailed it by answering that options seem overpriced.

In comparing implied vs. historical volatility we're trying to get a sense as to whether options (implied vol) are over or underpricing the amount of volatility we're expecting the underlying to realize throughout the duration of the trade. Rather than randomly guessing how much volatility a stock is expected to realize, most traders use historical volatility as a gauge. What better way to forecast future volatility than by looking at what's happened in the past?
As Shakespeare stated in The Tempest:
Whereof what's past is prologue, what to come,
In yours and my discharge.
If indeed past is prologue, then historical vol may well give us an accurate read of how volatile the stock will be going forward. Thought it's probably better than guessing, there are caveats aplenty to this method. First and foremost being that historical vol doesn't take into consideration upcoming earnings announcements. If you drive a car long enough by looking in the rear view mirror instead of through the windshield, you're bound to crash and burn at some point.
[Source: Livevol Pro]
Within the volatility chart displayed above, you can see implied volatility (68%) trading much higher than historical volatility (40%). If you were of the opinion that the stock was going to continue to realize 40% vol, then you'd prefer to sell options as they're too pumped up.

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