Categories: Trading

Misusing Historical Volatility and Implied Volatility Crossovers in Options Trading

Volatilities vary in design and construction. So that they may theoretically price option spreads into the future, retail traders must learn to trade options with a focus on what is material, such as the distinction between Historical Volatility and Implied Volatility.

The volatility of an asset, as recorded by its price changes in the past, is known as its “historical volatility,” or “HV.” Statistical volatility is the most well-known form of HV; it estimates the return on an asset over a fixed, user-specified period. The term “finite but adjustable” necessitates some clarification. Time-based moving averages and momentum/oscillator studies are constructed by selecting a specific number of days to quantify the Statistical Volatility, such as 5, 10, 50, or 200. With Implied Volatility, however, this is not the case.

Implied Volatility is a method for gauging future values based on the iterative improvement of bid-ask forecasts. These projections are founded on market participants’ hopes and fears. The bid and ask values reflect the estimates of the day’s buyers and sellers. They may adjust their positions as new information, such as macroeconomic news or microeconomic data affecting the underlying product, becomes available. The underlying asset’s future volatility is predicted by incorporating specific assumptions into the underlying asset’s informational flux. Options have expiration dates, so any adjustments to the bid-ask spread must be made before they lapse. This is why option contracts include time limits of 30 and 90 days, respectively. You cannot “construct” a period that yields faster or slower crossover signs by altering the expiration periods by reducing or increasing the number of days.

Why pay attention to how improperly people apply the Historical Volatility and Implied Volatility Crossovers? This is to warn you that HV-IV crossovers are unreliable trading indications and should not be misused. Keep in mind that there is only one volatility that may be used for a particular expiration month. Implied Volatility must move away from its present trading level and approach zero on the expiration date. At expiration, the Implied Volatility for all strikes must equal zero, regardless of whether the underlying price moved up, down, or stayed the same.

If one were to repeatedly sell “overpriced” options and buy “underpriced” ones, the implied volatility of all non-zero bid options would converge to a single value. This means the “smiling” skew seen in IV will no longer be there, and the surface of IV will become flat. In highly liquid products, this rarely occurs. Consider the broad-based SPY Index or the actively traded SPDR Shares ETF GLD in a volatile market like gold. If tens of thousands of contracts were available at the non-zero bid strikes, how likely is it that a retail trader off the floor can “outprice” a professional hedger on the floor? Unlikely. There is a lot of supply of calls and puts in highly liquid products like there is a lot of demand for those products. Because floor traders must rely on the trading of Calls and Put to make a living, they will not allow this stock to be “mispriced” since they cannot afford to take the risk of doing so overnight.

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As a retail trader, how can you best protect your advantage?

Compared to ITM strikes, which are rich in intrinsic value but have little in the way of extrinsic value, the percentage influence of IV on the extrinsic value of ATM and OTM strikes is substantially more significant. For obvious reasons, ATM and OTM strikes are the most popular among retail options traders with account balances of USD 25,000 to $50,000 (or less). It’s more expensive to trade ITM strikes since the Bid-Ask spread widens the further out of the money (ITM) you go compared to the Bid-Ask spread disparities in the ATM or OTM strikes.
Trading IV entails either purchasing time decay for a rise in IV at a discount of a percentage point below the theoretical price of market value or selling time premium for a drop in IV at a tip of a percentage point above the market value. Price debit spreads are to get filled at 0.10–0.15 below the spread’s Theoretical Price, depending on the day’s market ranges. Credit spreads are sold by increasing the credit by 0.10 to 0.15 points over the spread’s theoretical price. Your advantage is the amount by which the price you pay for or get for a feed deviates from its Theoretical Price due only to the price performance of Implied Volatility. Always price a spread to fulfill an order at its forward value in theory, never at its backward value.
Where can I find information on Implied Volatility-only (and not Historical Volatility) options trading that reliably generates a profit? To examine an example portfolio for a retail options trader that avoids HV in favor of trading solely IV, click on the “Consistent Results” link below.
I’ll use these historical examples to show why you shouldn’t use Historical Volatility in your trading.

Widespread fear resulted from a significant drop in Chinese stock prices on February 27th, 2007. It would have affected those who trade index options on indices like the FXI, an iShares product consisting of the 25 most important and most liquid Chinese businesses listed in the US but located in China. While it may be argued that similar market occurrences could produce similar Dow, Nasdaq, and S&P ranges, it would be difficult to have a similar scenario in which the VIX and VXN jumped 59% and 39%, respectively.

Rates were reduced by 75 basis points by the Federal Reserve on January 22nd, 2008, before a policy meeting on January 30th, during which the FOMC reduced rates by another 50 basis points. You would have been affected if you traded options on a Financial Exchange Traded Fund (ETF), a Banking Index such as the BKX, or a Housing Index such as the HGX, all tracking interest rate-sensitive industries. Moreover, with interest rates already so close to zero, the Federal Open Market Committee (FOMC), despite still having a rate policy instrument, cannot reduce rates by the same basis points as in the past. The past cannot be repeated in its entirety, at least not in the foreseeable future, unless and until interest rates are first raised and then lowered.

To what extent is it possible to piece together the past? That’s what happened to create Historical Volatility, and it’s fascinating. As with any other historical event connected to finances, the solution can be found in the listed real-world instances. It’s possible to sound similar to HV, but you can’t replicate the whole thing. So, if you keep employing HV-IV crossovers to try and find volatility “mispricing” patterns, you’ll wind up visually confusing yourself and making less money than you could have. Focusing just on IV and spreading volatilities trading across various asset classes outside of equities makes more trading sense.

Where can I find more information regarding trading IV without owning stock using solely options across several asset classes? To learn how to trade implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs, and Emerging Market ETFs, check out the video tutorial at the link below.

I appreciate your interest in my article.

Lee Clinton.

I founded Home Options Trading, a brokerage specializing in options trading for individual consumers.

For the Model Portfolio’s Performance Year to Date, updated at the end of each month, please visit Consistent Results ([http://www.homeoptionstrading.com/consistent_results/]). The portfolio simulates the investments of a retail, do-it-yourself option trader with a capitalization of up to US$50,000. In a nutshell, these are the numbers:

Profit compared to cash on hand at the beginning of the year indicates a return of 75.62%.

Chance of Success = 90.48 percent. Nine victories for every single defeat. There were 3.09 wins for every loss, on average. The performance ratio is 90.48 times three dollars and ninety-nine times one loss, or 2.80. Money-making potential per deal equals $1,051.

Visit [http://www.homeoptionstrading.com/original_curriculum.html] for a sneak peek at a 55-hour video-based course on online options trading from the comfort of your own home.

If you buy the course, you’ll also get a free $800 options introductory course.

For the past 16 years, Clinton has worked in treasury, finance, and banking for many companies, including Hewlett-Packard, JP Morgan Chase, Citibank, and most recently, ABN Amro (bought by RBS) in Asia, where she was a corporate director for regional business development. He had worked in banking and finance for many years, but that experience did not assist him in understanding how to trade options from home.