While there are many implied volatility indicators, not all are created equal. In this article, we will explore five of the most important implied volatility indicators. These indicators can be helpful for both experienced and novice traders alike in gauging the market's volatility expectations and responding with appropriate trading strategies.
Implied volatility is a measure that seeks to quantify the expected movement of a security's price. It differs materially from historical volatility, which is calculated from the known past returns of a security. Implied volatility is a forward-looking measure of future volatility as opposed to a backward-looking measure of realized volatility.
Before digging deeper into the concept implied volatility, it’s helpful to establish a basic understanding of the more basic concept of standard volatility.
Volatility measures price movements — through returns — of a security over time. Simply put, it is the rate at which a stock's price rises and falls over time. Higher stock volatility typically signals higher risk and a greater likelihood of future price fluctuations. Because volatility is calculated through returns that have been realized in the past, it is considered a backward-looking measure.
Implied volatility measures the expected future realized volatility of a security. If a security exhibits higher implied volatility, it means that investors expect it to experience greater price swings in the future.
Because implied volatility is a key input in the market price of options, higher implied volatility increases the value of option premia, otherwise known as the price a trader pays for an option. In that respect, another way to interpret implied volatility is simply to view it as the price of an option. Implied volatility is in fact less useful at predicting future prices of the underlying than it is at simply communicating the value of the option.
Academic research points to implied volatility as a better predictor of future realized volatility than historical volatility. It also has shown that the predictive quality of implied volatility tends to vary with the volume of options. Therefore unlike measures of standard volatility, implied volatility appears to exhibit significant informational content. Changes implied volatility are generally considered accurate signals of changes in the market’s perception of changes in future return volatility.
Volatility is traditionally calculated by using the standard deviation of the logarithmic returns of a security over time. In statistics, standard deviation measures the amount of variation or dispersion of a set of values. The purpose of the volatility measure is to express the degree to which the returns of a stock tends to vary from its mean return. As such, standard deviation is a fitting input to include in a standard calculation of volatility.
There are in fact a wide range of different methods that financial professionals use to measure a stock’s volatility. While the formulas used to calculate volatility may differ, they share a common thread in that they all aim to capture the tendency of a given security to fluctuate over time.
The volatility measure known as beta is one that is commonly used by portfolio managers. As a measure of relative volatility, beta seeks to communicate how an individual asset moves in relation to the overall market. A US stock whose beta value exceeds 1 can be considered likely to rise when the S&P 500 rises, but to a greater degree than the index itself. Likewise when the index falls, high beta stocks are expected to decline more than the benchmark.
Because implied volatility measures expected returns that have yet to occur, building models to approximate its value is more challenging than building models to calculate standard volatility. Nevertheless, Implied volatility is commonly calculated by inputing the market price of an option into the Black-Scholes formula and then back-solving for the value of volatility. It’s important to note that when traders apply different models applied to the same market option prices, they will produce different implied volatilities.
As a rule of thumb, implied volatility usually increases during bear markets and decreases during bull markets. This is becasase
There is ongoing debate over whether implied volatilities have predictive value when it comes to forecasting the future price movements of securities.
We’ve assembled a list of what we consider five of the best implied volatility indicators for traders of US equities. Each measurement has its own strengths and weaknesses, so it's important to understand how they work before you start using them in your trading. With a little practice, though, you'll be able to use these indicators to gauge market sentiment and make more informed trading decisions.
The world's premier barometer of equity market volatility, the VIX Index details the expected change in the value of the S&P 500 over the next 30 days. The value of the index is derived from S&P 500 Index options for the 30 days following its measurement date. Critics of the VIX cite that it functions primarily as an indicator of variance, rather than volatility.
Like the VIX itself, the VIX3M is a constant measure of implied volatility for the S&P 500. However, because it measures volatility over a three-month timeframe, the index tends to be less volatile than the VIX, which measures one-month volatility. The 3-Month Volatility Index is also normally higher than VIX, a condition called contango.
You can identify periods of time when the market is bearish and bullish by comparing the value of different indexes. By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish. Such a condition might be highlighted by that ratio trading over 1, which happens when the VIX futures contracts enter a period of backwardation.
This shorter-time frame indicator estimates the expected volatility of the next nine days. There are two additional forms of VIX9D, VSTN and VSTF, that estimate the expected volatility in stock returns by incorporating the near term and far term S&P 500 Index option series, respectively, into their calculations.
This index estimates the expected volatility of the stock market over a span of six months. It is calculated by analyzing S&P 500 Index options with a time frame of 6-to-9 months.
The backtesting and data visualization web app Tradewell tracks thousands of indicators, including many measures of implied volatility. Not only does the platform allow traders to monitor all of the five broad-market implied volatility metrics mentioned in this article, but it also tracks a large number of the single-stock and ETF-based volatility indices originating from the CBOE volatility index family.
For traders who prefer to track the implied volatility of individual equities, Tradewell also offers its premium members tools to monitor hundreds of fixed maturity and fixed strike implied volatilities for individual stocks.
And for traders hungry for even more implied volatility indicators, Tradewell offers a wide range of proprietary volatility spreads such as VIX-MAD, an indicator which measures the spread in value between the VIX Index and the Mean Average Deviation for the S&P 500. Experienced traders will recognize that this indicator is used to measure the "volatility risk premium or discount", or, said another way, the cost of options in implied volatility compared to the Mean Average Deviation (MAD) of the underlying asset.
A full list of all implied volatility indicators can be found within the documentation pages for the Tradewell platform. And because the Tradewell is both a backtesting and analytics web app, traders can not only monitor these indicators, but also measure and analyze how changes in their values have historically impacted the future price of specific securities.
Implied volatility indicators can be a great tool for traders, providing information that can help them make more informed decisions, especially as relates to risk. However, it's important to understand that not all implied volatility indicators are the same.
It is imperative therefore that traders become familiar with a variety of implied volatility indicators so that they can apply the one that best fits the scenario they are trading.
In addition, traders should be aware of the limitations of these indicators and use them in conjunction with other tools in order to increase their chances of success.
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