J AUTO TRADING STRATEGIES, LLC: October 2016

Tuesday, October 25, 2016

Implied Volatility Vs. Realized Volatility

Implied Volatility Vs. Realized Volatility

Why Premium Sellers Have An Edge

(Study Provided By The Tasty Trade FinancialNetwork)

Implied volatility is described as a one standard deviation annual move.

One standard deviation encompasses 68.2% of movement, so a one standard deviation range in a stock means that the stock should trade in that range 68.2% of the time. Implied volatility is a forward looking calculation. When implied volatility is high, premium sellers are able to receive higher credits for the sale of their options and the underlying stock can experiences a larger range in which it will trade, increasing probability of success. Selling option premium at one standard deviation creates the starting point for the "profitable range" in which we set up our trades. If we sell an option strategy with option strikes at one standard deviation, we will “expect” to be profitable 68.2% of the time. With this trade setup we can reasonably expect a probability of success of 68.2%.However we have found that in periods of both low and high implied volatility, there exists a large edge between our “expected probabilities of success” and our “actual or realized probabilities of success”

The Study: Does Implied Volatility Understate Realized Volatility?

[I]mplied volatility is almost always higher than actual or realized volatility. This means that if we expect to have a 68.2% probability of success on a particular trade, we end up with an actual or realized probability of success even higher than this. Basically we expect a stock to move in a certain range 68.2% of the time, but in reality, when implied volatility overstates realized volatility, like in this chart, it moves much less than that.

As long as implied volatility continues to be higher than realized volatility, an option premium seller's edge will be maintained. However option premium sellers do not need to rely only on implied volatility staying higher than realized volatility as their only trading edge.

There are many other factors that give premium sellers a leg up on the rest of the market. So even in periods where realized volatility is higher than implied or expected volatility (1995, 2008, 2013), option premium sellers can still be profitable due to the many other trading edges they experience, including the ability to profit simply from time passing.

U.S. Government Required Disclaimer

Commodity Futures Trading Commission. Futures, options, and spot currency trading have large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don’t trade with money you can’t afford to lose. This website is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.

CFTC RULE 4.41

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.

Futures trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.