Types of Volatility

Volatility Types

The last few chapters have formed a base of sorts to aid our comprehension of Volatility. We are now aware of what it implies, how to find it, and how the volatility data can be applied in constructing trading policies. It’s time to return to the primary subject – Option Greek and especially its 4th element “Vega”. Before we delve further into Vega, we have to talk about an imperative topic – Quentin Tarantino.

Let’s take an example of Quentin Tarantino and understand concepts: 

For evaluating the potential stock market success of a security, we look at Historical Volatility. The idea is comparable to using Tarantino’s prior directorial works as a gauge of how ‘The Hateful Eight’ would do at the box office. We take the closing prices of the stock/index and compute its Historical Volatility in Chapter 16. Not only is it easy to calculate, it also serves practical purposes – like providing approximate option prices (subsequent chapters discuss this in more detail).

Forecasting volatility is like a movie analyst attempting to predict the success of ‘The Hateful Eight’. Analysts in the stock market world likewise try to anticipate the level of volatility over a chosen period.

Why bother predicting volatility? Many option strategies hinge on your outlook for volatility. Take a view, say expecting it to swell by 12.34% in the course of seven trading days, and you can put together deals that can capitalize on this opinion – provided it’s accurate.

At this point, you should understand that to make money in the stock markets it is not essential to have a prediction of the market direction. Many professional options traders base their strategies on volatility and not necessarily market direction. Furthermore, numerous traders discover that predicting volatility is often more efficient than forecasting market movement.

Using a mathematical/statistical model for predicting volatility is much more reliable than just speculating. One of the most popular models is known as Generalized Auto Regressive Conditional Heteroskedasticity (GARCH). That may sound intimidating but it’s a great way to forecast volatility. The GARCH (1,1) or GARCH (1,2) processes are two of the best options out there.

Implied Volatility (IV) is comparable to the popular opinion on social media – it is largely unaffected by what historical data or movie analysts have to say. People’s enthusiasm towards a movie is usually a good indication of its success, and this concept applies to IV too: it displays the consensus of insight from all market participants as to how much an option’s price will fluctuate over time. As such, you could consider implied volatility as being ‘consensual’ in nature, in comparison to the artificially created historical and forecasted volatilities. Implied volatility is discounted in the cost of the premium.

Since the three different types of volatility can be considered, the IV is typically regarded as being most important.

You may have noticed or heard of the India VIX index on the NSE website. This is the official ‘Implied Volatility’ index and it is calculated using a mathematical formula. For more information on this, please refer to the white paper which explains how it works.

If the computation seems daunting, then here is a quick rundown of India VIX that comes straight from NSE’s whitepaper –

1. NSE calculates India VIX based on the Nifty Options order book.
2. The best bid-ask rates for Nifty options contracts for the current and following month are taken into consideration for calculation of India VIX.
3. India VIX gives an idea of the market’s volatility over the next 30 days – a measure of how nervous investors are likely to be.
4. As the India VIX rises, heightened volatility can be expected and conversely, when it decreases, lower levels of volatility are likely to follow.
5. When the markets are in flux, they can move drastically, causing the volatility index to increase.
6. The India VIX, also known as the ‘Fear Index’, is used to measure market volatility. When it declines, this indicates a less volatile environment. Conversely, rising values suggest investors should exercise caution as the markets could move sharply in either direction. Volatility indices are a tool at an investor’s disposal to help them form decisions about the market.
7. The Volatility Index differs from a market index such as the NSE Nifty. The latter reflects the current market direction, determined by the price movements of stocks, whereas India VIX is an indication of anticipated volatility, calculated using the order book for the related NIFTY options. Unlike Nifty which is a single figure, India VIX takes the form of an annualized percentage.

Furthermore, NSE provides the implied volatility for multiple strike prices of all options that are transacted. Examining the option chain is a great way to keep track of such volatilities.

We can calculate Implied Volatilities by utilizing a typical options calculator. We’ll delve further into calculating IV, as well as utilizing IV when setting up trades, in our following chapters. Now let’s move on to understand Vega.

Realized Volatility may be likened to a movie’s outcome, which can only be known when it is released. Looking back in time, Realized Volatility helps us determine the actual volatility that occurred during the expiry series. This comes in handy when we compare current implied volatility with the historical implied volatility. We will discuss this further when we delve into Option Trading Strategies.