Category Archives: Volatilty Forecasting and Trading
On 09-03-2013 Microsoft MSFT, announced that it is buying the handset units from Nokia, NOK. Nokia stock moved up over 16 standard deviations on the news. The chart below is a daily chart of Nokia, the red bars show the price move in standard deviations. The line on the bottom is the IV/SV ratio, notice how the implied volatility rose dramatically in the days prior to the announcement, a signal that something was happening.
No, I’m not discussing political leadership changes in a foreign country due to intervention or a coup. The term “regime change” also applies to the stock market. The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upwards with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility. Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85% of the time the market will trend higher with low volatility. We’ll call this “state one”. About 15% of the time the market will be in “state two” characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90% probability.
Ok, so what does this type of quantitative research mean to investors? What it means is that if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings. Long term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.
What this can mean for option traders is that if we are in a period of high volatility, we can expect the market to eventually return to normal which means that the high volatility will eventually subside and we can expect to profit from strategies that involve selling options and collecting premium.
Investors who followed the price action of TVIX today witnessed a great example of what can happen when using leveraged and inverse ETNs. The TVIX is designed to give an investor twice the daily price movement of the VIX. If you want to place a hedge and think that volatility is going to rise, the TVIX should give you double the action of the VIX and make for a good hedge when IV is rising.
Today the VIX rose and TVIX got crushed. In February, Credit Suisse announced that it was not going to create any more shares of TVIX. As a result TVIX is driven by market forces and can trade at a premium or discount to its indicative value, like the NAV of a closed end fund. The last few days TVIX has been trading at a substantial premium to its NAV. Because Credit Suisse is not creating new shares the algorithm that allows it to track its index, the VIX could not work and the mass selling on very high volume brought the shares down to an all time low. Volume was more than two and a half times its three month average. Today’s fall was almost 30 percent. Yesterday it had closed over 80% above its indicative value at $14.43. Today it closed at $10.20.
When using any leveraged or inverse funds investors need to do their homework and know what they are buying and how to apply them to a trading or investing strategy. Before purchasing a levered or an inverse fund it is critically important to understand the structure of the fund. They have added risks. The funds are designed to move up by twice the amount of an index, or move up if an index declines or move up double or triple the amount an index declines on a daily basis. The key word here is daily. Over longer time periods they will not perform with double leverage. Due to what’s known as ‘roll costs’ and after factoring in how daily market volatility works, the funds may not perform well over longer time periods.
You can own a leveraged index fund, watch the index gain over a long time period and see the leveraged fund decline in value. Here’s a real world example as reported by the SEC, the Securities Exchange Commission. Between December 1st, 2008 and April 30th, 2009 a certain index gained 2%. A leveraged fund that delivered twice the daily performance fell by 6%. During the same time frame an ETF seeking to deliver three times the daily performance of an index fell by 53%, while the underlying index gained about 8%.
Before using a leveraged or inverse fund, check past price action to see if it is performing as it should relative to its index. Check the fundamentals of the issuer for changes to its credit rating or if they have suspended issuing any new shares.
ETNs can be great tools for portfolio management, but one must understand the risks.
Understanding Stock Market Volatility
I think that it’s important for option investors to have some understanding of basic statistics, especially standard deviation and lognormal distributions. Many option traders use volatility trading, that is they don’t trade by forecasting the direction of a stock price movement, but trade based on a forecast of the volatility. I closely monitor the volatility or standard deviation of the equities and ETFs that I trade. Basically, there are different types of option volatility that we evaluate. Historical volatility is the standard deviation of the past history of the underlying. Future volatility is what the volatility will be going forward, typically the period that is the life of the option contract. If the underlying has been through a period of low volatility you may expect it to rise, if it’s been through a period of very high volatility you may anticipate the volatility will quiet down for awhile and consider limited risk strategies that will capitalize on lowering volatility. The option investor will study the historical volatility to help determine what may happen with the future volatility. Another type of volatility is forecast volatility which is a forecast of what the future volatility might be. GARCH (generalized auto-regressive conditional heteroskesdasticity) models and GARCH variants can be useful tools for volatility forecasting. These three types of volatility are all related to the underlying instrument, the stock or ETF. Another type of volatility is related to the option contract and is determined by consensus of all of the participants in the market place and is derived from the Black-Scholes options pricing model and that is the implied volatility. When looking at a quote of an option price, check the implied volatility of the option compared to the historical volatility of the underlying. Is it significantly higher or lower? If it is, check the news wire and see if there’s a reason for the pricing. If the implied volatility is high and you’re looking at a stock check to see when the next earnings release date is or if there’s a major product announcement or lawsuit pending. When I am considering entering an option position, I’ll check the implied volatility of the options under consideration. I’ll pay close attention to the relationship between the implied volatility of the option and the historical volatility of the underlying investment. I’ll consider the current standard deviation plus some longer term history of the range and trend of the volatility. In addition to looking at the current implied volatility of the option, I’ll also look the longer term history of the implied volatility of the options. I guess we could call that the historical implied volatility. Since the implied volatility is the current volatility priced into an option, when you trade an option you are essentially making a forecast of the future implied volatility. If you think that the implied volatility is too low and will rise you should consider a strategy that will profit from rising volatility, like a long straddle if you want to be direction neutral or delta neutral. If you believe that the implied volatility is too high and that the volatility will decline in the future you should use a position that will profit from falling implied volatility like a credit spread or iron condor or iron butterfly.
Implied volatility is the one element of the Black Scholes model that must be estimated. Implied volatility can be derived from the formula using the current market price. Options that have a high implied volatility will be expensive and options that have a low implied volatility will be considered cheap. In general we want to sell something that’s expensive and buy something that’s relatively cheap. So if we’re bullish on a stock and believe that the stock price is reasonable, we’re willing to own it and we think that the option price is high due to the implied volatility, we may think it’s a good time to sell a put. If you’re bearish on a stock, believe that it is overvalued and think that the options are cheap due to low implied volatility an investor may wish to purchase a put. Conversely if you’re bullish and think the implied volatility is low you may want to buy a call. If you’re bearish and think that implied volatility is high you may want to sell a call.