Volatility is a measure of the degree to which security prices fluctuate, and is therefore one of the simplest forms of measuring price risk. There are two key measures of volatility:
• Historical volatility, which is a backward-looking measure, is calculated as the variation (or standard deviation) of security price changes over a particular period e.g. standard deviation of daily percentage movements over the past three months.
• Implied volatility is the market’s forward-looking measure of expected volatility in a security price, implied by the prices of call or put options on that security or index. It is calculated by inputting the option’s key parameters into the Black-Scholes fair value option pricing model to derive the implied volatility over the period remaining until expiry of the option.
What’s the upside of trading volatility as an investment strategy?
Trading volatility as an investment strategy can be attractive because it tends to move inversely with market movements. When markets fall, volatility tends to rise and stays elevated. Volatility also tends to mean revert, or move back towards its long-run average levels, after periods of exceptionally high or low levels. Traders can therefore either choose to own volatility, if it is expected to rise, or short sell volatility, if they expect it to fall. This can be achieved by using derivatives such as futures, swaps or exchange-traded funds linked to market volatility measures such as the S&P 500’s VIX index, which is often referred to as the fear index (see below).
Because a security’s implied volatility may differ from its historical volatility, traders can also attempt to profit or arbitrage this difference. Implied volatility is often higher than historical volatility as investors typically overpay for put options, which act as a form of portfolio insurance. To capture this higher implied volatility, traders sell both put and call options on the same security and hedge this exposure by buying an underlying position in the security.
Another form of volatility trading is designed to exploit what is referred to as volatility smiles and skews, as well as the term structures of volatility. What these terms mean is that implied volatility tends to change depending on how far the option’s exercise price is from the current price. For example, a call option which is exercisable at a price 30% higher than the current price will typically have a higher implied volatility than an option that is exercisable at a price only 2% higher. Additionally, implied volatility will also vary depending on the option’s time to expiry, for instance a call option that has six months to expire may have an implied volatility that is lower than an option with one month to expiry. Put options also tend to have higher implied volatilities than call options with the same expiry date and exercise price.
Benefit vs Risk
The benefit of volatility trading is that it has the potential to make money regardless of whether security prices rise or fall. It also seeks to exploit price anomalies in the options market. Likewise, owning volatility can be a good hedge for other risky assets, since it can perform well when markets are falling as investors bid up the price of put option insurance.
Trading volatility has its risks. Whilst volatility typically spikes up when markets fall, there are occasions when prices gradually decline, without increased volatility, so owners of volatility may not benefit. There are also times when historical volatility exceeds implied volatility – for example strong rises in prices. Volatility trading also requires that underlying assumptions about the behaviour of prices continues to hold true, whereas in reality prices can jump up or gap downwards (for example due to profit warnings or takeover offers) which can lead hedged positions, becoming unhedged, creating losses.