Not all volatilities are built equal. Differentiating between historical volatility and implied volatility is critical, so retail traders learn to trade options by focusing on what is important to theoretically price option spreads going forward.

Historical Volatility (HV) measures the past price movements of the underlying asset by recording the actual or realized volatility of the asset. The best known type of HV is statistical volatility, which calculates the performance of the underlying assets over a finite but adjustable number of days. Let me explain what “finite but adjustable” means. You can vary the number of days to measure statistical volatility: for example, 5-10-50-200 days, this is how time-based moving averages and momentum / oscillator studies are constructed. However, this is not the case for implied volatility.

Implied volatility measures expected values ​​by repeatedly refining the supply and demand estimates. These estimates are based on the expectations of buyers and sellers. The buyers and sellers (more than 85% of the volume traded on the floor is driven by institutions, traders on the floor and market makers) behind the bid and ask values, who change their estimates during the day, as new information, be it macroeconomic or microeconomic news. -Economic data are available that impact the underlying product. What is being estimated is the future fluctuation of the underlying asset with certain assumptions incorporated in the changes in the information of the underlying. Such refinement of the supply and demand estimates must be completed within option expiration periods with a finite time limit. This is why there are monthly and quarterly option expiration cycles. You cannot change these expiration periods, either by shortening or lengthening the number of days, to “build” a time period that gives you faster or slower crossover indicators.

Why point out the incorrect use of the historical volatility and implied volatility crossovers? It is to warn you against faulty use of HV-IV crossovers, which is not a reliable commercial signal. Remember, for a given expiration month, there can only be volatility during that specific period. Implied volatility must start from where it is currently trading to converge to zero on the expiration date. Implied volatility (either IV for ITM, ATM or OTM strikes) should return to zero at expiration; but the price can go anywhere (go up, down or stay stable).

Continually selling “overvalued” options and buying “below price” would eventually cause the implied volatility of each non-zero bid option to line up exactly. Which means that IV’s skewed “smile” phenomenon disappears as IV becomes perfectly flat. This hardly happens, especially in very liquid products. Take, for example, the SPY, a broad-based index; o GLD – the SPDR Shares ETF in a fast market like gold. With an open interest in non-zero bid strikes running into the thousands and tens of thousands, do you really believe that a retail trader who is not on the floor will be allowed to “beat the price” of the professional hedger on the floor? Unlikely. Call and put options on highly liquid products are like high-supply inventory items because there is high demand. This type of inventory is not “mispriced” because floor traders have to earn a living on a daily basis by negotiating call and put options; they will refuse to take the risk of setting incorrect prices overnight.

So what are the key considerations for banking to your advantage as a retailer?

• The percentage impact of IV on the extrinsic value of an option is much more important for ATM and OTM strikes, compared to ITM strikes that are loaded with intrinsic value but lack extrinsic value. Most retail options traders with an account size of $ 25- $ 50k (or less) gravitate toward ATM and OTM strikes for affordability reasons. The deeper the ITM, the wider the Bid-Ask spread becomes compared to the narrower differences of the Bid-Ask spread on ATM or OTM strikes, making ITM strikes more expensive to trade.
• When you trade with IV, you are buying downtime for an increase in IV by one percentage point below; or, time-of-sale premium for a drop in IV by one percentage point above the theoretical price of the market value, which the participants are willing to pay or sell. Depending on the market ranges of that day, the price debit spreads will fill in at 0.10-0.15 below the theoretical price of the spread. With credit spreads, increase credit to sell the spread between 0.10 and 0.15 above the theoretical price of the spread. The price you pay next; Or, receiving above the theoretical price of a spread is your advantage, based purely on the price performance of implied volatility only. Remember, you theoretically price a spread to fill the order at its forward value, never the other way around.

Where can I learn to trade consistent profit options focused on implied volatility without historical volatility? Follow the link below, titled “Consistent Results” for a retail options trader portfolio model that excludes the use of HV and focuses on trading IV only.

I will cite these actual historical events to reinforce the case for completely removing historical volatility from your trading process.

February 27, 2007: Widespread panic over massive stock sell-off in China. If you were trading the options of an index like FXI, which is the iShares product of the 25 largest and most liquid Chinese companies in China, although they are listed in the US but are based in China, you would have been affected. While you can argue that it is possible for market events to recreate the ranges of the Dow, Nasdaq and S&P, how do you recreate the scenario in which VIX and VXN skyrocket 59% and 39%?

January 22, 2008 – The Fed cuts rates by 75 basis points before the policy meeting scheduled for January 30, causing the FOMC to cut another 50 basis points on the date of the meeting. If you were operating in interest rate sensitive sectors using the options of a financial ETF or a banking index such as the BKX; Or, the housing index like the HGX, would have been affected. And in today’s near-zero rate environment, the FOMC, while still having a rate policy tool, cannot cut rates by the same number of basis points as before. What was a historic event cannot be repeated successively in the future, not until rates are raised again and subsequently lowered again.

Question: How do you reconstruct the story? That is the history of the events that formed the Historical Volatility. The answer lies in the actual examples cited, as with any other financially related historical event: history cannot be reconstructed. You may be able to mimic parts of HV, but you can’t repeat it in its entirety. Therefore, if you continue to use HV-IV crossovers, you are visually confused looking for “mispricing” patterns of volatility that you would like to see; But instead, you’ll end up with poor earnings performance. It makes more practical business sense to focus exclusively on IV; Then diversify volatility trading across multiple asset classes beyond equities.

Where can I find out more about IV trading in multiple asset classes using only options, without owning stocks? Follow the link below (video-based course), which uses IV Mean Reversion / Mean Repulsion and IV Forecasting, as reliable methods for trading implied volatilities in broad-based stock indices, commodity ETFs, currency ETFs, and ETFs. emerging markets.