# Options - Better To Buy or Sell?



## wayneL (15 April 2012)

I've been writing a bit on this lately and thought it might be of interest here.

Discuss....

~~~~~~~~~~~~~

This is the question perpetually asked by retail option traders, often having been tainted by BS from some hyped up moron on a stage. I guess the question in their mind is over the long term,whether the negative theta of long options is too costly to be overcome by the long gamma and therefore it is better to sell options and take the other side of the equation.

In this simplest form it ignores volatility and presupposes that one should 'always' be either a seller or a buyer.

Professionals rightly point out that if options are correctly priced, there is no long term advantage in either buying or selling options. In my experience as a retail trader of some length of time, I am quite prepared to accept that as broadly true.

However, most retail traders, seem to fall on the side of selling options, or rather being nett short premium and short gamma at inception at least. Certainly a short gamma strategy where the short strike(s) are somewhat out of the money will have a higher than 50% win rate, which makes it 'feel' like it's a better way to go. However the win rate is irrelevant if the relatively fewer but higher losses, outweigh the more numerous but smaller wins.

Sometimes it can take neophyte option traders some time and a bend at the end of the trend to realize this.

Perhaps the most absurd reason I have seen is the claim that "80% of all options expire worthless", so it is much better to sell than to buy. Apart from this being at worst complete bollocks and at best a misrepresentation, it is irrelevant as discussed above. The actual figures I will detail in another post, but let's put our thinking caps on here.

Supposing XYZ is trading at $50 and I sell a $40 put, is there an 80% chance of the put expiring worthless? That's entirely possible, but what if I sold the call instead? Is there also an 80% chance of the call expiring worthless?

 Of course not.

What if I sell the ATM $50 put or call? There would be about a 50% chance wouldn't there? I could belabour this point further, but you get the point that chance of expiring worthless is dependent on several factors.

The question of whether to be a buyer or seller, if the question is couched in terms of always being a buyer or a seller, is the wrong question in my view. It is often asked because neophytes fall in love with a particular strategy and try to impose it onto every market condition. An example of this are the traders that have been sold a course on bull put spreads or covered calls and try to trade that strategy at all times. Real life invariably teaches these people that these strategies, though perfectly good strategies when appropriate, do not fit every market condition.

The question I want to ask is - What is the best strategy right now, at this point in time, for this particular market?

Before that can be answered, one must have a view of direction, volatility and the possible magnitude of changes in these. An understanding of how it might be if it blows up in your face is also essential.

Therefore the answer to the question posed is - it depends.


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## wayneL (15 April 2012)

*Re: Options- Better To Buy or Sell*

In a recent post I was discussing the question of whether it is generally better to be a buyer or seller of options. My conclusion was that theoretically there is no inherent advantage in either buying or selling, if options are priced correctly; it depends on the situation.

The oft repeated mantra out there in options land is to sell when options are overpriced and to buy when underpriced. Wise advice, but of course the sixty four thousand dollar question is - when is an option overpriced and when is it underpriced?

Of course if you know your option theory, you'll know the great variable in option pricing is volatility, all other inputs being known definitively.

We can measure the volatility of the underlying by looking back over a set number of days and applying a formula to determine the statistical volatility over that time frame. This is also definitive, but unfortunately may bear no relation to the volatility realized over the same number of days henceforth.

This is the volatility option traders want to know, future volatility. As it lies in the future, it cannot be known. Therefore the market collectively makes a forecast of future volatility and prices options accordingly, hence the measure derived by a little bit of algebra, 'implied volatility'.

Some folks suggest comparing implied volatility to statistical volatility to determine over or under valuation. I say that's naive. As discussed, statistical volatility looks backward, but implied volatility looks forward and as I've already pointed out, the volatility realized going forward can be markedly different to the preceding period.

What the individual trader must therefore do, is to make a call on future volatility and decide whether options are fairly valued or not, according to his or her own projections. Statistical volatility may be a tool that can be used in this analysis, but ultimately he who guesses best, wins.

Of course there are other dynamics at play depending on the specific strategy which may sink or save any one position, but good forecasters of volatility have a huge edge.

In the next post, I want to have a look at how accurately 'the market' forecasts volatility.


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## sinner (16 April 2012)

*Re: Options- Better To Buy or Sell*



wayneL said:


> Some folks suggest comparing implied volatility to statistical volatility to determine over or under valuation. I say that's naive. As discussed, statistical volatility looks backward, but implied volatility looks forward and as I've already pointed out, the volatility realized going forward can be markedly different to the preceding period.
> 
> What the individual trader must therefore do, is to make a call on future volatility and decide whether options are fairly valued or not, according to his or her own projections. Statistical volatility may be a tool that can be used in this analysis, but ultimately he who guesses best, wins.
> 
> ...




Onya wayne...I tend to agree with it all. My epiphany in this regard is that trading vol is all about being 'naturally' on the right side of payoff asymmetry. That is, if a trader is 'wrong' about their expressed market view, the value of their expression does not go down very much while if they are 'right' then the value of their expression increases asymmetrically.

When vol is high, the payoff asymmetry leans towards selling options. When vol is low, the payoff asymmetry leans towards buying options. Note, I am not claiming this is an edge of itself, but it is an important concept to try and stay on the 'natural' side of this lean.

Seems intuitive, but I only 'clicked' with the concept fully after seeing this table from condoroptions about 'best time to trade iron condors'



http://condoroptions.com/2007/11/26/the-best-time-to-trade-iron-condors-part-1/
highlights the payoff asymmetry of this options strategy.

Of course, as someone who likes to be long vol, my version of the above table is inverted.


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## village idiot (16 April 2012)

Tend also to agree with everything you've said wayne, but would like to throw in that its not just whether you buy or sell, it's also what you do afterwards, that makes the 'strategy'

there are broadly two ways to play ways to play long/short options between the time you buy or sell and expiry;
1. is to do nothing and live with the result at expiry. This is a bet on distribution of returns.
2. is to dynamically adjust your position to either take advantage of (if long) or defend against (if short) subsequent volatility. The most common way would be delta hedging but there is no reason adjustments cant be made by more buying and selling of puts/calls where appropriate. This is a bet on subsequent volatility. 

That is a broad generalisation but straight away we now have 4 basic strategies, not 2
1. sell premium and live with outcome
2. sell premium and hedge /adjust
3. Buy premium and live with outcome 
4. Buy premium and hedge or adjust to lock in profits

Of course combinations of the above are possible, and the hedging stategies then require a further strategy for how often to adjust,  making endless possible strategiy permutations

The results of strategies 1 and 3 depend only on the stock price on expiry day. they care nothing for subsequent realised volatility on the way (except for the fact that higher volatility means a greater range of possible stock prices at expiry) or vega or gamma. A consideration here is therefore not what RV might be  but  is the tendancy to trend or mean revert of the stock or index. If the options in question were somehow priced exactly at whatever RV turned out to be over the life of the options, then any tendancy to mean revert would give an edge to the short, and any tendancy to trend would give an edge to the long.  
Strategies 1 and 3 also have little or no transaction costs. 

the outcome of Strats 2 and 4 on the other hand depend almost entirely on the subsequent realised volatility between inception and expiry, and where it ends up is largely irelevant. Both the strategies carry transaction costs to factor in but here it becomes a little assymetric;  both long and short want as little transaction costs as possible, but the short is very  happy if he doesnt have to do any hedging (stock price never moves to his adjustment thresholds) and would tend to have wider thresholds,   whereas the long needs and wants lots of adjustments because that is where his profit (or at least reduction in losses) is coming from. Yet every time he makes a profitable adjustment he gives a significant amount of it back in transaction costs. 

It should be noted that if there is a buyer and a seller both opening a trade at inception, it is quite possible for them both to win (or lose) if they then take differnt strategies from then on.   Suppose a straddle is traded at 15% IV. The long takes strategy 4 and the short strategy 1.  RV turns out to be 20% but the price ends up near the stike at expiry. Both sides of the original trade 'win'. 

My guess is that new options traders would tend towards strats 1 and 3, whereas more sophisticated traders gravitate towards 2 and 4. I have a feeling that you are assuming everyone takes the dynamic approach as you do, but not everone who buys or sells an option is trading volatility.  

To summarise my overlong post, its not as simple as saying should i be a 'buyer' or a 'seller'


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## wayneL (16 April 2012)

Good posts guys. 



village idiot said:


> To summarise my overlong post, its not a simple as saying should i be a 'buyer' or a 'seller'




Spoiler alert!!

This is where I want to get to with this thread... in a convoluted way. Sans qualification, it is the wrong question.

However the convolution is necessary to get through the logic so that it makes sense (hopefully); so stand by for more convolution.  Extra input welcomed.

Though I think there are times where it makes sense to be either long or short gamma (as proxy for being a nett seller or buyer).


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## village idiot (16 April 2012)

oops, sorry

but I like to see this sort of discussion so will look forward to the more convolution...


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## wayneL (16 April 2012)

No need to apologize No Village Idiot.

Its great to get some good options discussion on ASF.


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## wayneL (19 April 2012)

Continuing on with relevant posts from the blog;


In a couple of recent posts viz, Is It Better To Buy Or Sell Options? and Buy/Sell Musings & Volatility, I've been looking at the trader's bias of being a either a buyer or seller of options, or at least being nett short or long gamma. 

The conclusion I have reached, for whatever that is worth, is that the decision generically boils down to volatility. That is to say that the trader must examine the volatility priced into the option, AKA implied volatility, and decide whether the price is at, over, or under the odds; or in option parlance, whether the option is fair value, over, or undervalued.

Some writers suggest a comparison to historical volatility, but I wrote in Buy/Sell Musings & Volatility that I thought that was naive and an inappropriate way of determining relative value. Implied volatility looks forward; it is the collective markets guestimate of the volatility it thinks will be realized in the future, in other words the market's view of correct value for that option. It is not definitive, cannot be definitive, because we don't know what will happen in the future.

Historical volatility is definitive however because it measures actual prices traded in the market place over a set of past data of the analyst's choosing. This can be any period, but most commonly over the preceding 20 or 30 days of data. For the purposes of this article I am going to use 20 day historical volatility as this represents the approximate number of trading days in one month.

The VIX is an index of near term implied volatility on S&P 500 options and is quoted according to a formula, to smooth out implications of impending expiry etc. Details and method of calculation are available from the CBOE at this LINK. Essentially it is recording implied volatility one month henceforth.

As I have stressed up til now, it looks at past data, whereas implied volatility looks forward and what happens in the next 20 trading days may be vastly different to what happened on the last 20 trading days, volatility wise. It does have it's uses however. It allows the analyst to examine the 'normal' range of actual volatility for an underlying instrument, how it's cycles, what has been its upper and lower boundaries under various market conditions etc.

Historic volatility has a further use. We can use it to measure how accurately the market forecast one month volatility by looking at the actual volatility realized in on month's time, via the historical volatility calculation.

Let's have a look at the S&P500 using VIX as proxy for implied volatility available at a given date and realized volatility one month later.






As we can see in the above graphic, on the 1st of Feb the market overestimated volatility substantially, therefore we can say that on that date and with the benefit of hindsight, we would have been better to have been a seller of options, all other considerations aside.

Manipulating the historical volatility plot backwards by one month makes it easier to analyze by lining up the implied volatility with the volatility realized in one month later.






In the data that we can see in this graphic, the market collectively forecast volatility correctly, finally, in about the third week of March. So we can say, again with the benefit of hindsight, that S&P500 options at that point were fair value, though it is only today, one month later, that we can say that.

The displaced historical volatility plot gives us the opportunity to view the implied volatility at any point in the past and also in toto, to see how well the market forecasts volatility over the long term. The graphic below shows, on SPX options at least, that the market tends to over estimate forward volatility chronically.






That is it overestimates future volatility until it doesn't. Sellers at market tops get taken to the woodshed.

This evokes the 'picking up pennies in front of a steamroller' cliche for put sellers and synthetic equivalents (buy/write traders) and bull put traders. Put buyers who successfully pick tops score a big time try/touchdown/<or goal scoring nomenclature appropriate for your country> with the vega bomb that blew up in the seller's face. (With apologies for mixing metaphors there)

As intimated in the preceding paragraph, of course being short or long options is not the only consideration. Delta, gamma and theta also cohort the make the trade; or wreck it as the case may be. In markets swoons put buyers will be celebrating with festive dinners, Dom Perignon and Cuban cigars while quite obviously call buyers will be drowning their sorrows with rough red, despite being on the correct side of the buy/sell divide.

The overriding point here however is that market estimations of volatility aren't very accurate and I believe an edge can be obtained by being a better forecaster of volatility and I believe such analysis can help traders make better option trading decisions and not be stuck in a permanent buy or sell paradigm.


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## mazzatelli (21 April 2012)

Also if one is inclined, they can look at the implied vol surfaces. For example its commonly known that index bear deltas are associated with increase in implied vol.

But there is evidence that implied vols move along the skew. Provided the gains in skew > loss in implied vols there are trading opportunities. 

Buy or sell in this case? Well generally with this type of position one can't help be short gamma into a decline


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## village idiot (21 April 2012)

Hi Wayne

nice post, keep them coming. tis a shame it's not generating any discussion since this is my favourite subject, so looks like its just you and me 

re;



> I believe an edge can be obtained by being a better forecaster of volatility




are you getting around to telling us how to be a better forecaster than the market? 


on a pedantic note VIX is a reasonable proxy for the relative IV of SPX options, except that it is usually higher than the IV of at the money options due to the weighting of out of the money puts in the vix calculation. IMO the at the money straddle is the best representation of IV at any time, so if you were going to use vix as a proxy you would have to allow for the fact that it is a higher figure than you could actually sell/buy an atm straddle at.


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## ROE (21 April 2012)

The way I play options is pretty simple.

I have intimate details of 10 rock solid stocks  and I continuous write for premium (put and call) which rarely get assigned.... I get around 10-25% P/A in premium depending on the stocks and its IV ..

say I outlay 200K for writing options premium I get any where between 10-25% return
depending on stocks combination...

QBE for instance awesome premium juicy stuff, so far pocket around 5K premium without a single assignment ... I made more money on WDC options premium than
I ever did as a stock holder  ..

I don't trade I hold till expiration but I have multiple position spread out with each month at least two contracts expire so it gives me flexibility to take on new opportunity when I spot risk/reward .... I will never be in a position where if everything assigned even early I don't have the cash to back it up.....

Dont care about spread or any other options techniques, in a way I'm like the insurer
I calculate my payout risk which is the risk of getting assigned with my stocks out of the money compared to trading price...

I dont use formula or any complex maths or charts, because I understand the business well I can use very simple maths to calculate the risk in my head...

I can look at the premium,strike price and expiration date and I know if I should get into that contract or not in that instance..

There is no doubt in my mind that one day I will get assigned but I should collect enough premium to justified the risk..

my friends ask me about options even though I play them all the time if you ask me about those spread or hundred different options combination I know didly squad 

I keep thing extremely simple in investing in stocks as in derivative like options.
no spread sheets, no secret formular, no complex maths or charts  

Unconventional but works for me at least....


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## VSntchr (21 April 2012)

When you write calls, Im assuming that you are writing covered calls, ROE?

Ive started considering a few naked puts now that the contract sizes have become smaller (which is good for those with less capital!), but as I don't own any of the ASX20 stocks I am unable to write any covered calls at this stage..


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## ROE (21 April 2012)

VSntchr said:


> When you write calls, Im assuming that you are writing covered calls, ROE?
> 
> Ive started considering a few naked puts now that the contract sizes have become smaller (which is good for those with less capital!), but as I don't own any of the ASX20 stocks I am unable to write any covered calls at this stage..




Yes covered call, I don't like naked call ... I like to know my risk rather than exposure to limitless risk

Say I bought a whole load of QBE at between 12-14 bucks and when it rally I write covered called $15.50  I did one during the frenzy of capital raising and some optimism in QBE price. That expire in about 1 month and a half and at this stage look like will expire worthless...unless QBE rally past 15.50 from now till end of June..


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## wayneL (22 April 2012)

village idiot said:


> are you getting around to telling us how to be a better forecaster than the market?



Hmmm well as Mazza intimated (I think) volatility is inversely correlated to market direction, as pointed out this is well known.

Hence though I've stressed that IV looks forward ie purportedly proactive, I think we can all see a reactive component to it. So in most cases forecasting volatility likely to be realized, basically boils down to taking a broad brush view of market direction, or non-direction as the case may be.

There is also the phenomenon of volatility being mean reverting and/or cycles from highs to lows and back again. 

In long grinding trends there is the likelihood that risk will start to get underpriced, in swoons there come a point where it is overpriced.

A study of these interplays and an understanding of probabilities hopefully can give us a lead into selecting the right strategy(s).



> on a pedantic note VIX is a reasonable proxy for the relative IV of SPX options, except that it is usually higher than the IV of at the money options due to the weighting of out of the money puts in the vix calculation. IMO the at the money straddle is the best representation of IV at any time, so if you were going to use vix as a proxy you would have to allow for the fact that it is a higher figure than you could actually sell/buy an atm straddle at.




True enough.

But I need something to plot, and for at least some traders it will be a close enough reflection of real IVs to study what I'm talking about.... BTW I wish I could get those VIX IV values for OTM calls. :


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## noirua (22 April 2012)

I wont interrupt too much as I realize a few here know far more than I do.  About 2 years ago I started shorting stocks in the UK, moving later on to the AIM market when it started sliding in 2011.
Of course the UK still uses MMs (Market Makers) which adds to the fun, though the market itself is not run as well as the ASX and you can be conned by some of the goings on. 

Several bulletin boards, ADVFN and iii to mention just a few, allow virtually any post to be made and rarely does anyone bat an eye lid, and it's obvious at times that teams of posters arrive to ramp or de-ramp.

Just posted this so some will see that it is possible in the game of risk to just pick a market that is in decline and virtually go for it -- it becomes addictive if I don't watch out.

The ASX200 has lagged most of the markets. For instance, the FTSE100 bottomed at around 3,400 as did the ASX200. Now the footsie is at 5,800 and ASX200 not at 4,400. So I think, with the Aussie in decline, that we will see the ASX indexes rising quicker than many can possibly imagine and not a market I would short. Going long could be more advantageous though Aussie markets fret with rumours about Spain and Italy.

Remember always that if you are in options you are a 'trader', not an investor -- there is a very big difference.

Good luck! Will follow this interesting thread -- noi


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## persistentone (23 April 2012)

wayneL said:


> I've been writing a bit on this lately and thought it might be of interest here.
> 
> Discuss....
> 
> ...




For 90% of retail investors, options are a suckers game.  You can get hurt so many ways, not least of which is:

- directional risk on the underlying asset

- shrinkage (or growth) in implied volatility of the option

- bid ask spreads that are often 15% of the option value, making trading around the position extremely expensive

If you are a mathematics and statistics genius, then of course you are playing to your strengths to deal with options.   You can certainly make money exploiting volatility mispricing that is short term.   I think that however is well beyond what most retail investors would be good at.

I have found that there are specific situations where a retail investor can safely hold options, and in no particular order these are:

- Any time you want to buy a stock in layers as it comes down, selling puts is a great strategy.   What most people don't understand is that placing a limit order to buy a stock at a specific limit is in fact taking on risk to capital.   If the stock collapses by 50% tomorrow, you have risk of loss that you cannot easily control.   So by selling a put you at least get paid time premium as compensation for taking on market risk.    

Generally I want to be near the money and to maximize premium.   A rough calculation I make is that I want to be making about 10% of the capital potentially invested as my time premium for an option that is to be held for six months.

Employing this strategy, you must learn to size your positions carefully.  If no one stock is going to take more than 5% of your portfolio (for example, your number may be different), then size the options so that if you are assigned you don't end up with more stock than meets your risk allocation rule.

- When you want to sell some of a stock that is a long term holding, selling a long dated call can have significant tax benefits.   Here is US we pay a lower capital gains rate if you hold the stock more than one year.   So I had one stock for example I bought at $6 that went to $30 in six months.   It became 20% of my portfolio, so I knew I needed to rebalance.   The volatility was huge, so I sold covered LEAPs that expired in 14 months at $8 to $12 per LEAP (!!).    If the stock continues to rise, you get assigned after one year and get the long term capital gain rate, plus you take the time premium.   If the stock settles back, the time premium was enormous and you get an advantaged tax rate on the gain from the option.    

I usually do NOT like covered calls.   I think that they steal your upside while offering neglible defense of your downside risk.   But in a case where the position is getting too large and you plan to sell anyway, I like them as a risk balancing tool.

- If a stock is really washed out, and volatility goes low, and you have a strong opinion about direction on the stock, then I like long calls that are very far dated *IF* the time premium for that is neglible.    Recently I bought some October $3 Calls on a stock that trades at $5.75 for $2.85.   They charged me 10 *cents* for time premium that goes way out until October.    So I am getting a free ride on time and tremendous leverage on the trade.    If the stock stays flat, I can exercise the option and trade out of the stock without needing to deal with the huge bid ask spreads.   To me that is a trade any retail investor can do without becoming a math genius on volatility.  The rule is go long options when you understand direction and you don't pay anything for time premium.  It's rare to have those opportunities, but sometimes you get lucky.


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## sinner (25 April 2012)

wayneL said:


> But I need something to plot, and for at least some *traders* it will be a close enough reflection of real IVs to study what I'm talking about.... BTW I wish I could get those VIX IV values for OTM calls. :




Another thing about payoff asymmetry in the pedantic vein, it's rare to long vol in the front month (so as to avoid theta) just as much as it's common to short vol in the front month (to encounter theta).

So it's not just that ATM straddle is a better representative, but the straddle with >30 days to expiry...


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## mazzatelli (25 April 2012)

mazzatelli said:


> But there is evidence that implied vols move along the skew. Provided the gains in skew > loss in implied vols there are trading opportunities.



 I should add that this requires a forecast of direction as well. Modelling the skew as sticky deltas, when the spot touches the strike, there should be contamination (thanks Taleb).

Not something retail usually looks at, but there for anyone interested.


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## mazzatelli (13 May 2012)

Realized vol:

How about making adjustments to possibly improve its measure:
1) scale down one-off events which have minimal effect on future vol
2) replacing actual earnings returns with an average (or any empirical central moment statistic) earnings value?



b = large one off mvmt expressed in stdevs e.g. if r_{a} > 2 stdevs, then it is adjusted
E = earnings​


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## sinner (13 May 2012)

Gee maz, that's quite an equation for 9:30AM on a Sunday!

GARCH!


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## sinner (13 May 2012)

Took me only about 20 minutes of google to find some really good info on:

#1 Find the best ARMA model for a subset of time-series.
#2 Apply the ARMA model to optimal ARMA model with a GARCH(1,1)
#3 Use the resulting to predict/forecast next in time-series. 

in R. For free. Total code less very small, just consists of a few API calls. Does being a compsci absolve me of not understanding all the underlying stats (I get the gist?)? :

Maybe not too useful for returns (then again ) but apparently, very very useful for predicting/forecasting (monthly) volatility. 

What if my time-series is mazzas jazzed up realised vol equation?



> The overriding point here however is that market estimations of volatility aren't very accurate and I believe an edge can be obtained by being a better forecaster of volatility




Suddenly my head is spinning...


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## mazzatelli (14 May 2012)

sinner said:


> Gee maz, that's quite an equation for 9:30AM on a Sunday!



 Yeah, my life ain't so interesting these days!



sinner said:


> Took me only about 20 minutes of google to find some really good info on:
> 
> #1 Find the best ARMA model for a subset of time-series.
> #2 Apply the ARMA model to optimal ARMA model with a GARCH(1,1)
> ...



 Ha! Yes it can be looked at in GARCH format, but slightly different. My emphasis was more on smoothing large events when calculating realized vol, operating on the assumption that these events don't have a large bearing on future vol. I'm not sure what Wayne used to calc hist vol above, I'm assuming its just the normal stdev calc (if so it would contain more noise than what I've suggested).


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