The Volatility Cone

[wayneL]

I will post the excel spreadsheet I'm working on here and we can discuss how to use a volatility cone. As a primer here is a bit of blurb from amex (one of the US options exchanges)

Volatility Cone

A technique for visualizing current option implied volatility relative to historic volatilities at different maturity ranges. This technique, developed by Galen Burghardt, uses the range of historic volatilities for each option's maturity from, say, one month to two years or longer, depending on the maturities of instruments available in the market. An historic volatility series is calculated for each period and 25% and 75% confidence intervals on either side of the mean historic volatility line are added. When the current implied volatility term structure is drawn on this diagram, the investor is able to determine how current option premiums compare to historic premium levels at various maturities.

... and a reminder that you can access IV/SV charts via this link http://sigmaoptions.netfirms.com/IVcharts/stockIV.htm

 

[ducati916]

As to useage;

*Conservative; regression to the mean
*Aggressive; High to low/Low to High

jog on
d998

 

[wayneL]

Looking Good,

Just a bit more tidying up and I will post the .xls file

 

[wayneL]

Finished the Volatility Cone version 1.0. The .xls file is too big to attach, so anyone who wants to have a look PM me with your email.

Questions here.

Cheers

 

[bingk6]

Hi WayneL,

I've a couple of questions on this most interesting concept. I have never seen anything like it before and it looks almost like a Bollinger band on volatility, if my interpretation of it is correct. The assumption here is that if IV approaches the maximum, then its value (based on historical Volatility) can be viewed as excessive, and one can therefore expect it to decrease over time and revert back to the mean. Therefore you would aim for strategies which are short Vega.

Vice Versa if IV approach the minimum, in which case, it can be expected to increase over time and also revert back to the mean and therefore aim for strategies that are long Vega.

1) Is my interpretation of what the cone offers correct ?

2) For the IV, would you recommend using the values from ATM, OTM or ITM options ? Also any preferences for using IVs from Calls or Puts ? I guess in theory, they should be all be the same (or roughly the same), but the skew can be quite pronounced at times.

3) Just looking at the cone shape itself almosts give the impression of an endorsement for a long calender spread, with the long call being bought at relatively stable IVs and the short calls available at a much larger range of IVs. Off course, this is not to say that the short term IVs are higher or lower than the longer term IVs, just that they are more volatile. Almost like a higher IV on an IV

I am curious as to whether you can look at the shape of the cone and deduce from that whether a calender spread is a worthwhile strategy for that particular stock, or have I entirely missed the boat??

 

[wayneL]

Hi WayneL,

I've a couple of questions on this most interesting concept. I have never seen anything like it before and it looks almost like a Bollinger band on volatility, if my interpretation of it is correct. The assumption here is that if IV approaches the maximum, then its value (based on historical Volatility) can be viewed as excessive, and one can therefore expect it to decrease over time and revert back to the mean. Therefore you would aim for strategies which are short Vega.

Vice Versa if IV approach the minimum, in which case, it can be expected to increase over time and also revert back to the mean and therefore aim for strategies that are long Vega.

1) Is my interpretation of what the cone offers correct ?

2) For the IV, would you recommend using the values from ATM, OTM or ITM options ? Also any preferences for using IVs from Calls or Puts ? I guess in theory, they should be all be the same (or roughly the same), but the skew can be quite pronounced at times.

3) Just looking at the cone shape itself almosts give the impression of an endorsement for a long calender spread, with the long call being bought at relatively stable IVs and the short calls available at a much larger range of IVs. Off course, this is not to say that the short term IVs are higher or lower than the longer term IVs, just that they are more volatile. Almost like a higher IV on an IV

I am curious as to whether you can look at the shape of the cone and deduce from that whether a calender spread is a worthwhile strategy for that particular stock, or have I entirely missed the boat??

This is quite new for me too. I have been working along these lines for some time and have been graphing this on a different set of axes. This is giving a different viewpoint, yet same conclusions.

FWIW I would be looking at this in addition and in conjunction to the normal 30daySD/IV graph eg:

1/ Yes, your interpretation is correct, with the added dimension of looking at the HV characteristics of the particular timeframe you are trading along the x axis.

2/ I would use the IV of the option(s) you are actually intending to trade, precisely because of skew etc

3/ Bear in mind that the cone plots the historical volatility of the option at various time horizons and we comparing the implied vol of the option we intend to trade against the HV at that time frame. As far as endorsement for calender spreads? Hmmmm it certainly could be useful in analyzing them. If I was trading them in a big way I would probably be coughing up for more comprehensive IV histories from the likes of Optionetics Platinum or ivolatility.com FWIW

I have noticed some stocks are much fatter at the long end of the expiry spectrum. This is telling me volatility could be much less predictable in these stocks. (jury still out on that one though)

Anyways, if you dream up new uses for it, be certain to post your ideas.

Cheers

 

[bingk6]

WayneL,

Many thanks for your detailed reply. It certainly does provide a new perspective on the "expensiveness" of option pricing when you are able to compare its IV over HV of the same expiry over a long period of time. Thanks for bringing it to our attention.

Whilst we are on the topic of volatility, I have noticed that the ASX website provides an estimate of the IV for each option series. Using this estimated IV, it is then able to generate what it considers a fair price for that option. Generally, when I trade through etrade, I have noticed that the bids/asks tend to gravitate towards this fair value pricing as estimated by the ASX. In other words, the market makers seem to have some kind of respect for the estimated ASX option pricing and generate their bids and asks accordingly.

This is not a problem for me, but what intrigues me is how the ASX comes up with its IV estimate in the first place. I use Metastock and have programmed in it the readily acceptable forumla for calculating IV (30 trading days) and the values generated via Metastock usually bears very little resemblance to the ASX estimate. My Metastock formula, on a daily chart is

Std(Log(C/Ref(C,-1)),30)*Sqrt(252)*100 - which I understand is very very standard.

I therefore have 2 more questions:

1) Does anybody know how the ASX arrives at its IV estimate, and
2) If there is a large discrepancy (either too much or too little) between the IVs generated by my Metastock formula and the ASX estimate, can one use this discrepancy in IV to come up with a relatively low risk trade ??

 

[wayneL]

WayneL,

Many thanks for your detailed reply. It certainly does provide a new perspective on the "expensiveness" of option pricing when you are able to compare its IV over HV of the same expiry over a long period of time. Thanks for bringing it to our attention.

Whilst we are on the topic of volatility, I have noticed that the ASX website provides an estimate of the IV for each option series. Using this estimated IV, it is then able to generate what it considers a fair price for that option. Generally, when I trade through etrade, I have noticed that the bids/asks tend to gravitate towards this fair value pricing as estimated by the ASX. In other words, the market makers seem to have some kind of respect for the estimated ASX option pricing and generate their bids and asks accordingly.

This is not a problem for me, but what intrigues me is how the ASX comes up with its IV estimate in the first place. I use Metastock and have programmed in it the readily acceptable forumla for calculating IV (30 trading days) and the values generated via Metastock usually bears very little resemblance to the ASX estimate. My Metastock formula, on a daily chart is

Std(Log(C/Ref(C,-1)),30)*Sqrt(252)*100 - which I understand is very very standard.

I therefore have 2 more questions:

1) Does anybody know how the ASX arrives at its IV estimate, and
2) If there is a large discrepancy (either too much or too little) between the IVs generated by my Metastock formula and the ASX estimate, can one use this discrepancy in IV to come up with a relatively low risk trade ??

1/ You can't "calculate" IV from stock price data, you can only calculate IV from the current option price using BSOPM or similar. What your formula above is calculating is HV. I have found the standard HV calculation as per your formula above fairly useless on Oz options in that as you notice, it bear no relation to IVs.

FWIW I have used the following HV formula on Oz stocks and works pretty well.

in metamumbojumbo code:

long:= (StDev(log(C/Ref(C,-1)),100) * sqrt(252))*100;
short:= (StDev(log(C/Ref(C,-1)),10) * sqrt(252))*100;
x1:= short - Ref(long,-1);
x2:= (x1* (2 / (10+1) ) ) + Ref(long,-1);
x2

See this thread for discussion: https://www.aussiestockforums.com/forums/showthread.php?t=2935&highlight=exponential

As far as the ASX sites calculations, nobody seems to be able to work them out... I think they are seriously lagging. lol

Cheers

 

[rugbreek]

I really would love to receive the vol cone spreadsheet. I used it a lot more than 10 years ago as an options marketmaker before becoming a farmer. Now my daughter is a novice options marketmaker and I want to introduce her to the value of cones. My mail is rugbreek@gmail.com.

Thanx in advance!!!