What is volatility, how do we measure volatility, and why do we care about volatility? Volatility is a little bit different than many other aspects of the market. We can see patterns, we can see volume, we can see movements between price levels but volatility is hidden, volatility must be calculated. Adam will cover True Range volatility, volatility compression, implied volatility and more!
Why Volatility Is Different
We can “see” most aspects of the markets’ movements easily.
- Movements between price levels
- Patterns or cycles
Volatility is different.
It must be calculated.
The volatility we see is a reflection of both
- “Actual” volatility
- The way we measure it
What Is Volatility?
An academic definition:
- A measure of risk
- Calculated as the standard deviation of returns
A more practical definition:
- How much something moves around
How about this?
- How much something is likely to move around in the future
Measuring Volatility in TWS
Ways to Measure Volatility
- Standard deviation of returns, usually annualized
Average True Range
- Range is high – low of each bar.
- Could be averaged over a time window
- True Range adds any gap from the previous close
Daily/weekly volatility-adjusted measures
Must be “backed out” from observed options prices
There are many academic models and measures
- GARCH-family models
When the ratio of short-term volatility to longer-term volatility is low, the market can be said to be in volatility compression.
When in volatility compression:
- Big moves out of compression are likely to continuation. In other words, momentum is likely to “win”.
Options are priced according to five factors:
- Price of the underlying
- Strike price of the option
- Time to expiration
- Interest rates (and dividends, if applicable)
Volatility is the only one of these that is not concrete.
We can look at existing options prices and calculate the volatility needed to “justify” those prices. This is implied volatility.
Options prices are often inflated ahead of anticipated events.
- Earnings for a company
- Crop report
Elevated implied volatility can be a warning that the market expects something to happen.
Lessons from Academic Models
Volatility is often modeled with complex mathematical models.
Volatility in most markets has a long-term average level to which it will tend to return.
In the short-term, recent volatility is the best measure of future volatility.
Volatility shocks fade away. (Think of the example of a large rock thrown in a quiet pond.)
The timing and arrival of volatility shocks is unpredictable.
Volatility must be calculated from prices and cannot be directly observed.
There are different ways to measure and calculate volatility. Understand which is best for you.
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