Ihab Salloum[ad_1]
Not all volatilities are created equal. You gotta know the difference between Historical Volatility and Implied Volatility, so you can focus on what really matters when trading options.
Historical Volatility (HV) tracks the past price movements of the underlying asset, recording its actual or realized volatility. When traders talk about HV, they usually mean Statistical Volatility, which calculate the asset’s returns over a set number of days. You can adjust this number of days – for example, 5-10-50-200 days – to build time-based moving averages and momentum/oscillator studies. But this is not something you can do with Implied Volatility.
Implied Volatility measures expected values by continually refining bid-ask estimates based on the expectations of buyers and sellers. These buyers and sellers, who make up the vast majority of floor traded volume, change their estimates throughout the day as new macroeconomic and microeconomic information becomes available. What’s being estimated is the underlying asset’s future fluctuation with certain assumptions embedded into the changes in information. These refinements of bid-ask estimates must be completed within finite time-bound option expiration periods, like monthly and quarterly cycles, which cannot be manipulated to artificially construct faster or slower crossover indicators.
Why is it important to distinguish between HV and IV? Because relying on HV-IV crossovers as a trading signal can lead you down the wrong path. For a given expiration month, there can only be one volatility over that specific period. Implied Volatility must leave from where it is currently trading at, to converge at zero on expiration date, but price can go anywhere. To continually sell “overpriced” and buy “underpriced” options would eventually cause the implied volatility of every single non-zero bid option to line up exactly. This phenomenon of IV “smiling” skew disappears, as IV becomes perfectly flat. This hardly ever happens in highly liquid products like the SPY or GLD, where calls and puts are like items in an inventory with high supply and high demand.
So how can retail traders gain an edge?
- IV’s impact on an option’s extrinsic value is much more sizeable for ATM and OTM strikes, versus ITM strikes, which are laden with intrinsic value but lack extrinsic value.
- When trading IV, you are either buying time decay for a rise in IV or selling time premium for a drop in IV at a percentage point below or above the theoretical price of market value, that participants are willing to pay or sell for.
Where can you learn more about trading IV? Check out the links below to see model retail option trader portfolios that exclude the use of HV and focus on trading IV alone.
Remember, historical events like the widespread panic from China’s 2007 sell-off or the Fed’s 2008 rate cuts cannot be easily repeated, making HV an unreliable tool. Focus on IV and diversify across multiple asset classes beyond equities.
Where can you learn more about trading IV across multiple asset classes using only options? Follow the links below for video-based courses that use IV Mean Reversion/Mean Repulsion and IV Forecasting as reliable methods to trade the implied volatilities across equity indexes, commodity ETFs, currency ETFs, and emerging market ETFs.
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