Types of volatility and how they can help you in Option Writing trades

Volatility is a very important number that goes into the decision-making process of trading options. It has a mean-reverting behaviour but volatility itself tends to be very volatile at times. It tends to have fat tails—large spikes are witnessed on black swan events which could be multi-fold of the mean number.

Volatility can be calculated by using many methods but three types—historical, implied and future-realized volatility­—are the most common and generally used in the decision-making process.

Before we get into details, let us understand the importance of volatility from an option writer’s perspective.

Volatility for option writers

Option writers with short positions in calls/puts carry a risk of rising volatility. Since they are short on volatility, if its rises, it can lead to significant losses. As an option writer, you would want to write options when volatility is high but generally, that is not the case as most of the time volatility is sticky at lower levels within a given regime.

Due to this behaviour of volatility, it is very important to keep a close watch on the number and if it starts rising, it may be an early indication to either exit or adjust your trades to protect from a volatility spike.

Let us now understand how the three types of volatility can provide signals of a probable volatility spike.

Historical volatility

Historical volatility is the standard deviation of the annualised daily returns of the underlying. Generally, it is calculated on a rolling basis to keep a recency bias.

Historical volatility has nothing to do with option prices as it is calculated purely using the underlying prices, but if the underlying prices become more volatile, it indicates a possible increase of volatility in the future. Hence, increasing historical volatility can be an indicator to possible spikes.

The limitation of this data is that it is backward-looking but due to the time-series correlation observed in stock markets, looking at historical trends can still add value.

Implied volatility

Implied volatility (IV) is what the market expects in the future. This is the price you trade in the market, and you will be a price taker since the market as a whole is large. Some technical or quant indicators can be applied to implied volatility to predict its direction but what happens in future could still be completely different.

I like tracking IV in tandem with historical volatility and future realized volatility. This means the difference between implied volatility with historical volatility can give you a better indication if you really need to panic or is it an opportunity. Do note that the difference between IV and HV may not be a good indicator in cases of known events like results, monetary policies, fiscal policies and economic data releases.

Future realized volatility

This is the volatility of what happens in the future. This is not known in advance but looking at the past future realized volatility can give an indication of how good the market predicted the volatility.

I look at this is as a difference between IV and FRV. The indicator will not be recent as the rolling number of days will act as a lag but still, the difference can provide indications if the underlying starts out-beating the market expectations and mostly in those cases, it tends to show a serial correlation. This can be an indicator to avoid writing trades or write with hedges in place.

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