Volatility Rules
Why Watching The VIX Is Important
I thought it was March that came in like a “lion” and left as a “lamb’. While that’s still the case, it appears that investors and traders are copying that same effect in January as we begin the new year.
From time to time articles reviewed here and on other sites do their best to describe the effect of volatility. In my book, “The Ticker’s Bible”, I often discuss volatility in a way that describes how I use it. It’s better taught in my one-on-one tutorials but it’s important to have a basis. With the VIX gapping higher to begin 2024, perhaps it’s a good time to define exactly what “volatility” is.
Times They Are A Changing
Volatility is a statistical measure of the dispersion of returns for a given security or an overall market index. The higher the actual volatility, the riskier the security or index is. Volatility is often measured from either the standard deviation or variance between returns from that same security or market index.
Volatility is the amount of uncertainty or risk related to the size of changes in a value. A higher volatility means that a value can potentially be spread out over a larger range of values. This means that the price can change dramatically over a short time period in either direction. A lower volatility means that value does not fluctuate dramatically, and tends to be more steady.
One measure of variation is the daily returns of the asset. Historical volatility is based on historical prices and represents the degree of variability in its return. This number is without a unit and is expressed as a percentage.
Variance captures the dispersion of returns around the mean of an asset. Volatility is a measure of that variance over a specific period of time so a daily, weekly, monthly, and annualized volatility is reportable. In my thoughts, I define volatility as the annualized standard deviation as I’m more “long-term” than not.
Volatility is often calculated using variance and standard deviation. Mathematicians call this “standard deviation”, the square root of the variance. This volatility describes changes over a specific period of time. Simply take standard deviation and multiply it by the square root of the number of periods in question:
Volatility = σ√T where:
v = volatility over some interval of time
σ =standard deviation of returns
T = number of periods in the time horizon
Again, not everyone is a mathematician or has the innate ability to handle calculations of this nature. On a one-on-one basis through The Ticker EDU tutorials I’ve been able to “drill down” on this formula but for this article let’s stick with the basics.
Types of Volatility
Implied volatility (“IV”), or projected volatility, is a very important metric for options traders. It allows them to make a determination of just how volatile the market will be going forward giving traders a way to calculate probability. It’s not a true science. No one can really forecast “exactly” how markets will move over time. Implied volatility comes from the “actual” price of an option itself and represents volatility expectations for the future. Traders cannot use past performance to predict a “future” performance. It’s an estimate of the potential of the option in the market, nothing more nothing less.
Historical volatility (“HV”) gauges fluctuations of underlying securities by measuring price changes over predetermined periods of time. It isn't forward-looking. When HV rises, price moves more than normal and traders expect that something will soon or it has already changed. If HV is declining, it means any uncertainty has been eliminated, so things return to the way they were.
Volatility Effects Options Pricing
Volatility is a key variable in options pricing models, especially estimating the extent to which the return of the underlying asset will fluctuate between now and expiration. Volatility is expressed as a percentage coefficient in option-pricing formulas. It arises from daily trading activities and how volatility is measured will affect the value of the coefficient used. It’s all “Greek” to me so it’s covered by simply assessing the “Greeks” and how they are applied to the options world. I have a section in my book that deals directly with what they are and how they’re used and an upcoming oral series through my Udemy courses. It’s simpler than it sounds so take the time to understand them.
Volatility is used to price options contracts using “Black-Scholes” or “binomial tree” models. Volatile assets translate to higher options premiums. With volatility there is a greater probability that the options will end up “in-the-money” at expiration. Higher volatility suggests higher option market prices across the board. Keep this in mind.
The VIX
Market volatility is observed through the Volatility Index (“VIX”), a measure of broad market volatility. The VIX was created by the Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the U.S. stock market derived from real-time quote prices of S&P 500 call-and-put options. It is a “gauge of future bets” investors and traders are making on the direction of the overall markets or individual securities. A high reading on the VIX implies a risky market.
Investors and traders can find periods of high volatility to be distressing as prices can swing wildly or fall suddenly. Long-term investors ignore “short-term” volatility and stay the course. Over the long run, stock markets tend to rise. Emotions like fear and greed, which can become amplified in volatility markets, undermine most “long-term” strategies. Some investors, like me, use volatility to “buy when “they” sell and to sell when “they” buy”. It’s one of my standard rules which is why I’m long the 2024 March 17 VIX calls.
Well it’s 2024. The first edition of the dust covered, hard back edition of “The Ticker’s Bible” and its sister electronic version has been approved. I’m working day and night to get the Udemy courses filmed, edited and available on Udemy. I’m shooting for the end of the month availability for both once The Ticker EDU has a functional website. I appreciate everyone who’s helped with ideas along the way and you, those who have patiently waited, especially my better half. It’s been a true labor of love; I thank you for support.
It’s hard to believe that almost sixty years ago Bob Dylan sang “The Times They Are A-Changin’” live in England. I had the pleasure of seeing Dylan perform while he still had a voice. Regardless of his “age”, he’s still a poetic talent. The times they are still a changing and face it, they always will. I wish I had access to the “computer” tools you are blessed with today. I’m still using a few of my more expensive HP calculators that helped to bridge the gap. One of them still runs the “Black Scholes” option model we put together at Carnegie-Mellon years ago. Some things just don’t change.