subject: Options Trading Strategies - Wrong Use of Historical Volatility and Implied Volatility Crossovers [print this page] Options Trading Strategies - Wrong Use of Historical Volatility and Implied Volatility Crossovers
Its not all volatilities are constructed equal. It is advisable to differentiate between Historical Volatility and Implied Volatility, so retail traders teach me to trade options focused on what's material to theoretically price option spreads forward.
Historical Volatility (HV) measures past price movements with the underlying asset recording the asset's actual or realized volatility. The greater commonly known kind of HV is Statistical Volatility, which computes the actual assets return more than a finite but adjustable length of time. Ok, i'll explain what "finite but adjustable" means. It is possible to vary the quantity of days to measure the Statistical Volatility: by way of example, 5-10-50-200 days, that's how time-based moving averages and momentum/oscillator studies are created. Though, it is not the situation with Implied Volatility.
Implied Volatility measures expected values by repetitively refining bid-ask estimates. These estimates provide the expectations of clientele. The clientele (85 % of floor traded volume is driven by institutions, floor traders and market makers) behind the bid and ask values, that do change their estimates within the day, as new information whether it be macro-economic news or micro-economic data impacting the underlying product opens up. What exactly is being estimated is the underlying asset's future fluctuation with certain assumptions embedded to the changes in information with the underlying. That refinement of bid-ask estimates has to be completed within finite time-bound option expiration periods. That is why you can find monthly and quarterly option expiration cycles. You can not change these expiration periods, either by shortening or lengthening the amount of days, to "construct" a period period that provides you faster or slower crossover indicators.
Why talk about a bad utilization of Historical Volatility and Implied Volatility Crossovers? It really is to caution you from the defective usage of HV-IV crossovers, which can be not only a reliable trading signal. Remember, to get a given expiration month, there can only be one volatility over that specific period. Implied Volatility must leave from where it really is currently trading at, to converge at zero on expiration date. Implied Volatility (whether it be IV for ITM, ATM or OTM strikes) must come back to zero on expiry; but, price might be anywhere (up, down or stay flat).
To continually sell "overpriced" and get "under priced" options would eventually result in the implied volatility of each single non-zero bid option to line up exactly. Meaning the phenomenon of IV's "smiling" skew disappears, as IV becomes perfectly flat. This hardly happens, specifically in highly liquid products. That will, the SPY, a broad-based Index; or, GLD - the SPDR Shares ETF inside a fast market like Gold. With open interest in the non-zero bid strikes going in to the thousands and tens of thousands, you may not think a retail over floor trader will probably be permitted to "out price" the professional hedger on the ground? Unlikely. Calls and Puts in highly liquid products, are just like products in a listing rich in supply while there is sought after demand. This sort of inventory doesn't get "mispriced" because floor traders must make a daily living from trading the Calls and Puts -they will won't carry the chance of mispricing overnight.
So, do you know the key considerations to banking inside your edge being a retail trader?
IV's percentage effect on an option's extrinsic value is a lot more sizeable for ATM and OTM strikes, versus ITM strikes that are laden with intrinsic value but lack extrinsic value. Most retail option traders having an account size USD $25-$50K (or less), gravitate towards ATM and OTM strikes for reasons of affordability. The deeper the ITM you decide to go, the wider the Bid-Ask spread becomes compared to the narrower Bid-Ask spread differences in the ATM or OTM strikes, making ITM strikes more pricey to trade.
When you trade IV, you are buying time decay for any increase in IV at a % point below; or, selling time premium to get a drop in IV at the % point above the theoretical tariff of monatary amount, that participants are willing to pay or cost. With regards to the market ranges of the day, price debit spreads to obtain filled at .10-.15 below the Theoretical Price with the spread. With credit spreads, improve the credit to trade multiplication by .10-.15 above the Theoretical Price in the spread. The cost to you below; or, receive above the Theoretical Price of a spread can be your edge, purely depending on price-performance of Implied Volatility alone. Remember, you Theoretically Price a spread to fill the order for the forward value, never backward.
Where can I teach me to trade options with consistent profits centered on Implied Volatility without Historical Volatility? Keep to the link below, entitled "Consistent Results" to view a model retail option trader's portfolio that excludes the use of HV and targets trading only IV.
I'll cite these actual historical events, to bolster the argument for removing Historical Volatility from the trading process altogether.
27 Feb, 2007: Widespread Panic from the sizeable China sell-off in equities. Had you been trading the choices of an index such as the FXI which may be the iShares product of China's 25 largest and quite a few liquid Chinese companies though listed in the usa; but you are headquartered in China, you'll are already impacted. While you are able to argue you can have market events recreate the ranges in the Dow, Nasdaq & S&P, how would you recreate the scenario from the VIX and VXN soaring 59% and 39%?
22Jan, 2008: Fed cuts rates by 75 basis points prior to the scheduled policy meeting on Jan 30th, whereby the FOMC cut another 50 basis points around the date of the meeting. Should you be trading interest-rate sensitive sectors using the choices on an economic ETF or perhaps a Banking Index just like the BKX; or, the Housing Index like the HGX, you'd happen to be impacted. And in the present environment of rates being near zero, the FOMC while they still need an interest rate policy tool, they cannot cut rates through the same number of basis points like before. That which was a historical event just isn't successively repeatable in the years ahead, not until rates are raised again and subsequently they get cut again.
Question: How can you reconstruct history? That is the history of events forming Historical Volatility. The reply is within the real examples cited, just like any other financially related historical event - you can't reconstruct history. You could possibly mimic aspects of HV but you cannot repeat it in their entirety. So, in case you continue using HV-IV crossovers, you visually confuse yourself by seeking volatility "mispricing" patterns that you want to see; but, you'll be with poor profit performance instead. It makes more practical trading sense to concentrate purely on IV; then, diversify the trading of volatilities across multiple asset classes beyond equities.
Where can I learn more about trading IV across multiple asset classes only using options, without needing to own stock? Keep to the link below (video-based course), that utilizes IV Mean Reversion/Mean Repulsion and IV Forecasting, as reliable methods to trade the implied volatilities across broad-based Equity Indexes, Commodity ETFs, Currency ETFs and Emerging Market ETFs.More info of options trading
