TT - BP: Volatility Expansion, 10/28/13

Volatility

• Q:  What does Implied Volatility (IV) represent?
• A:  IV represents a 1 Standard Deviation (1SD) move in the underlying for the next year. It is displayed as a percentage, meaning if AAPL has an IV of 0.3 then a 1SD move would be 30%. If AAPL is currently trading at $500 then it would have an expected move of +/- $150.

• Q:  Can IV be used to estimate moves of an underlying on a shorter time frame than 1 year?
• A:  Yes.  1SD Move = Price * IV * SquareRoot(DTE/365)

Using the above example of AAPL, the expected 1SD move in one month would be:

500 * 0.3 * SqRt(30/365) = $43

• Q:  What is the relevance of a 19.1% IV?
• A:  A 19.1% IV represents an expected move of 1% per day. Twice that IV, or 38.2%, means a 2% expected daily move.

• Q:  What is Realized Volatility?
• A:  Realized Volatility refers to the actual move of the underlying.

If AAPL (trading at $500 with an IV of 0.3) moves $100 in one year then its volatility is 0.2 (100/500) or 20%.

• Q:  What is IV Rank and how is it used?
• A:  IV Rank (or IV Percentile) shows where the IV currently sits in relation to a specific time period (usually one year). We have seen that IV is consistently a mean reverting metric and IV Rank allows us to capture this, putting it on a comparable scale. We look for underlying with high IV Rank to sell premium.

• Q:  What is the significance of Implied Volatility for each option expiration cycle?
• A:  The IV on a specific option cycle represents the given IV for that time period (expiration cycle). The IV on any given option chain will often appear similar to one another and the overall IV of the underlying. A vol discrepancy will often appear on the closest expiration after binary events, such as earnings.

• Q:  What is vol skew?
• A:  Vol skew refers to the fact that volatility and velocity is greater to the downside. Skew builds extra premium into the OTM put when compared to the equivalent OTM call. For this the options pricing model is based on a lognormal distribution, as a stock price cannot fall below zero.