Using Realized Volatility to Forecast Implied Volatility

Follow us on LinkedIn

Implied volatility is a measure of the expected fluctuations in a security’s price. It is used by options traders to gauge the market’s expectations for the future volatility of the underlying security. A higher implied volatility means that the market is expecting a greater price movement, while a lower implied volatility indicates that the market is expecting a smaller price movement.

Forecasting implied volatility is important for options traders because it can help them to anticipate the size of future price movements. This information can be used to make informed decisions about when to enter and exit trades, as well as how to adjust their trading strategies. It also helps traders to assess whether the options are under- or overpriced.

There are a number of different techniques that can be used to forecast implied volatility. Reference [1] examined the use of realized volatility to forecast future implied volatility for pricing, trading, and hedging in the S&P 500 index options market,

In this article we examine the incremental economic value of using RV in combination with option IV to forecast future IV for out-of-sample option pricing, trading, and hedging in the SPX options market. Based on a comprehensive out-of-sample analysis, we find that historical RV forecasts retain statistical superiority in the encompassing regressions and out-of-sample pricing tests, but do not have incremental economic value in option trading and hedging. This suggests that RV, which has significant economic value in volatility timing in asset-allocation decisions in the equity and bond markets, may not yield similar economic benefits in the context of SPX options markets in the presence of transaction costs.

In short, the use of realized volatility, in combination with implied volatility, resulted in superior forecasting performance. However, the predictive power of realized volatility did not lead to trading profits.

Does the latter point imply that it’s not useful to forecast implied volatility for options trading purposes? Let us know what you think.

References

[1] WH Chan, R Jha and M Kalimipalli, The economic value of using realized volatility in forecasting future implied volatility, The Journal of Financial Research • Vol. XXXII, No. 3, Pages 231–259, Fall 2009

Further questions

What's your question? Ask it in the discussion forum

Have an answer to the questions below? Post it here or in the forum

LATEST NEWSCanadians showing more support for striking workers amid inflation, corporate profits
Canadians showing more support for striking workers amid inflation, corporate profits

It was Samantha Henry’s first time on strike, and one that made headlines across the country. “Some people thought the strike would only last a week, a couple of days. And we went into almost five weeks,” said Henry, one of some 3,700 Metro employees…

Stay up-to-date with the latest news - click here
LATEST NEWSInflation likely gained pace in August, economists expect, reversing progress
Inflation likely gained pace in August, economists expect, reversing progress

OTTAWA — Economists are forecasting inflation reaccelerated to around four per cent last month, reversing previous progress made as gasoline prices push inflation higher. Statistics Canada’s August consumer price index report set to be released Tuesday is expected to show the annual inflation rate rose…

Stay up-to-date with the latest news - click here
LATEST NEWSUS national security adviser meets with Chinese foreign minister
US national security adviser meets with Chinese foreign minister
Stay up-to-date with the latest news - click here
LATEST NEWSShiba Inu (SHIB) Profitability Is Finally Back at Double-Digit Level
Shiba Inu (SHIB) Profitability Is Finally Back at Double-Digit Level
Stay up-to-date with the latest news - click here
LATEST NEWSA Fed decision, FedEx earnings and the UAW strike: What to know this week
A Fed decision, FedEx earnings and the UAW strike: What to know this week
Stay up-to-date with the latest news - click here

Leave a Reply