# Volatility



## omad (2 November 2006)

Hi,

As volatility is the only input in an option pricing model that we don't really know for certain, how do you determine what volatility to use as an input? I am guessing everyone uses a different method but would be interested in hearing how people determine this.

Also does anyone use Hoadleys Historic Volatility Calculator, if so how do you find the accuracy of this tool? I am particularly interested in the GARCH volatility forecasts.

Thanks.


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## Magdoran (2 November 2006)

omad said:
			
		

> Hi,
> 
> As volatility is the only input in an option pricing model that we don't really know for certain, how do you determine what volatility to use as an input? I am guessing everyone uses a different method but would be interested in hearing how people determine this.
> 
> ...



The other unknown variable is price! Hahaha... (unless you have a time machine of course - or can forecast well). I'll respond to your question more seriously soon...


Mag


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## Magdoran (2 November 2006)

omad said:
			
		

> Hi,
> 
> As volatility is the only input in an option pricing model that we don't really know for certain, how do you determine what volatility to use as an input? I am guessing everyone uses a different method but would be interested in hearing how people determine this.
> 
> ...



Hello omad,


Volatility is a difficult area to deal with since it is theoretical, and as you quite rightly point out is an unknown variable that is only determined by using a formula in line with the underlying price and the bid and ask of the option currently.

Let me flesh out the basic concepts for those unfamiliar with them before I address the core question:

If you look at both historical volatility and implied volatility, they are quite different measures, and many confuse the two.  Quite simply, historical (or statistical) volatility measures the current price movement in comparison to price history, and gives a measure of standard deviations.

Implied volatility measures the theoretical value of an option, and the deviation from the model based on supply and demand on the option currently.  The charts record the increases and decreases in premium based on a theoretical model price.  Usually this is expressed as a percentage.

So, looking at an IV (implied volatility) chart, we can see the swings up or down in volatility over time, and can overlay the price action of the underlying to compare the IV movements.

IV generally increases on significant moves in the underlying, usually more on a fast downward move, and tends to decrease generally in sideways or mildly trending (usually up) markets.  An exception to this is based on hype and media news and announcements.  Volatility can increase when there is anticipation of a possible large move in an underlying.

If you have good charting skills, and can also interpret volatility charts, you can anticipate where IV may move based on your view of what the underlying may do.  

If a stock for instance has been mildly trending up, and you expect a fast move down, you may consider buying a put with low volatility in the expectation that the volatility will rise significantly on a fast move down, augmenting profits.  This can be achieved with upward moves, but volatility tends to move more strongly with down moves.

Try overlaying stock movements and IV averages to see how the two correlate.  Also, consider surgically looking at just puts, or just calls, or at specific time frames (e.g. 90 days +, 30-60 days) depending on the timeframe and strategy you are considering.

If you believe that T/A approaches can be used to trade stocks, then perhaps you can extend this to learning to read volatility charts in a similar way.  In my view these have tradeable patterns just like the underlying, but can also be used in tandem with the underlying chart patterns too.

By the way, my focus is on IV, not HV.  I see HV as secondary, and just a measure of the statistical movement of the underlying, not the volatility in the option itself.


Hope this helps.


Regards


Magdoran


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## omad (4 November 2006)

Hi Magdoran,

Thanks for taking the time to answer, it does help confirm my understanding of volatility.

I guess what I am trying to do is develop a consistent method of determining weather options are under or over valued so I can make a decision on what strategy to use, based on my view of the underlying. Now correct me if I am wrong but there is a few ways of doing this;

1. Come up with a volatility forecast over the life of the option, enter this into your model then compare the model price to the current market price of the option.

2. Calculate the IV based on current market price of the option and compare this to? Not sure what I should be comparing this to, HV or IV chart? 

3. As you mentioned in your post, apply TA to volatility charts (IV charts?) and combining this with TA on the underlying come to a conclusion on where you think volatility will go.

At this stage the strategies I am looking at are long calls or puts if undervalued, vertical spreads if overvalued. But my problem is I am not happy with my ability to determine value.

Thanks.


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