Daily Volatility Overview

Volatility Forecasts:

We have our own proprietary Optima model to formulate our volatility forecasts on each of the underlying stocks, stock indexes and exchange traded funds (ETFs) based on implied and historical volatility. Optima determines whether an option is undervalued or overvalued by comparing its implied volatility with Optima’s volatility forecast for that option. If the option’s implied volatility is significantly above the option’s volatility forecast, then the option is overpriced according to Optima and likely to be attractive for selling covered calls.

What is Volatility?

Volatility is the relative rate at which the price of a security moves up and down. If the price of a stock moves up and down rapidly over short time periods, it has high volatility. If the price almost never changes, it has low volatility.

In the Black-Scholes model (a standard method of pricing options), volatility is the expected standard deviation of price changes. It is usually expressed as an annualized number. To calculate an option price using the Black-Scholes formula, you use five known inputs and an input that is an estimate. The five known inputs are; stock price, strike price, time to expiration, interest rate, and dividend (if there is one). The estimated input is volatility.

How do you arrive at this volatility input? One way is to observe what volatility the market is currently using to price options. This is known as Implied Volatility. One can use also past volatility, known as Historical Volatility. At California Investment Trust, we use a more forward-looking technique than simple historical volatility to come up with our Forecast Volatility.

Implied Volatility

Implied volatility is the theoretical value designed to represent the volatility of the security of the underlying an option as determined by the price the option. It is easy to calculate what the market thinks volatility should be at any point in time. You simply take the current option premium (as quoted) and use the five known variables and a Black-Scholes model to find the volatility number that would give you that particular premium. We call this metric implied volatility. Implied volatility is, in effect, the market’s forecast of future volatility.

Historical Volatility

In securities trading, historical volatility, refers to price fluctuation over a standard period such as a day, week, month, quarter, or year. Historical Volatility is computed by taking the standard deviation of price changes over the chosen period and is usually compared with the implied volatility in pricing an option. It is directly related to the level of risk associated with a security: low Historical Volatility means low risk, and high Historical Volatility means high risk.

Typically, when evaluating an option that expires a certain number of days forward, an option trader calculates the historical volatility of the stock over the same number of days in the past. Thus, the trader’s estimate of the worth of an option that expires in 30 days is likely to be strongly influenced by the past 30 days’ historical volatility. Likewise, a trader’s estimate for an option that expires in a year is likely to be strongly influenced by historical volatility over the past year. Thus, historical volatility is often used as a forecaster of future volatility. However, it is not always an effective forecaster because volatility often tends to be moving in one direction or another.