#realized volatility

[businesspostnigeria-blog]

Firm Unveils Volatility Index for Nigerian Stock Market By Quantitative Financial Analytics Stock market volatility is one of those words that are being thrown around every now and then when describing stock market behaviours.

[valuestox-blog]

New Post has been published on UNDERVALUED STOCKS

New Post has been published on https://www.undervaluedstocks.info/implied-volatility-realized-volatility/

Implied volatility and realized volatility

Volatility is an important consideration in the pricing of options.  Holding constant the strike price and expiration of an option, future volatility assumes a paramount position in determining the value of an option.

We don’t know with certainty the future volatility of a stock, but we can use option pricing models like the Black-Scholes Model to derive an implied future volatility.  If we know the values of all the other inputs into the Black-Scholes Model except for future volatility, we can use the model to solve for volatility.  Thus, for a certain option contract if the price is X and we assume that the price of the option is neither overvalued nor undervalued, then the expected volatility of the stock must be Y if we accept the assumptions of the Black-Scholes Model.

A thoughtful investor will wonder if expected volatility has anything to do with actual volatility.  In other words, if the option price implies a volatility of Y over the next year, a year from now what will the volatility have actually been?

This is an important question.  If implied volatility is less than the actual volatility in the future, then the price of the option is too low in relation to the potential payoffs. On the other hand, if the implied volatility is greater than the actual volatility in the future, then the price of the option is too high.

As one might expect, there are times where either happens.  Sometimes the actual volatility is greater (less) than the implied volatility, with potentially harmful (beneficial) effects for the person who owns the option.

However, on average, the evidence suggests that implied volatilities are too high on average over the long-term.  This implies that options tend to be overvalued and that, on average, buying them may not be a profitable decision.  Of course, the potential returns depend entirely on the specifics of the option contract and the performance of the underlying stock.  Past performance is no guarantee of future performance.