Volatility is often described as an asset class, but it is not an asset in the traditional sense. Volatility is a property of an underlying — the rate at which the underlying's price changes — and the volatility market is a market for the trading of this property. The options market is the primary venue for trading volatility, and VIX is the most widely-traded measure of volatility. This article explains the fundamental difference between implied and realized volatility, and the way the journal uses the difference to identify edge.
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Realized volatility
Realized volatility is the actual standard deviation of the underlying's returns over a historical period. The realized volatility is computed from the historical prices of the underlying, and the realized volatility is a backward-looking measure of the underlying's price movement.
The realized volatility is the property that the trader is trying to predict. The trader who is correct about the realized volatility will make money on the options position; the trader who is incorrect about the realized volatility will lose money. The realized volatility is the "true" volatility, and the implied volatility is the market's estimate of the true volatility.
The realized volatility has a few well-known properties:
1. Mean reversion. The realized volatility is mean-reverting over time: high realized volatility tends to decrease, and low realized volatility tends to increase. The mean reversion is the basis for the volatility risk premium: the option market tends to price options based on the assumption that the realized volatility will revert to the long-term average.
2. Clustering. The realized volatility tends to cluster: high realized volatility tends to be followed by high realized volatility, and low realized volatility tends to be followed by low realized volatility. The clustering is the basis for the GARCH models and the volatility forecasting literature.
3. Fat tails. The realized volatility is not constant; the underlying's returns have "fat tails" (extreme events are more common than the normal distribution predicts). The fat tails are the basis for the option market's pricing of tail risk.
Implied volatility
Implied volatility is the option market's estimate of the realized volatility over the option's remaining life. The implied volatility is computed from the option's market price by inverting the Black-Scholes formula. The implied volatility is a forward-looking measure of the underlying's expected price movement.
The implied volatility has a few well-known properties:
1. Higher than realized volatility on average. The implied volatility is systematically higher than the realized volatility, by about 2-4 percentage points on average. The premium is the volatility risk premium, and the premium is the source of the option seller's edge.
2. Forward-looking. The implied volatility is the market's estimate of the future realized volatility, not the current realized volatility. The implied volatility is more sensitive to changes in the market's expectations than to changes in the realized volatility.
3. Affected by supply and demand. The implied volatility is affected by the supply and demand for options. When the demand for options is high (e.g., during a market crash), the implied volatility increases; when the demand for options is low (e.g., during a calm market), the implied volatility decreases.
The volatility risk premium
The volatility risk premium is the difference between the implied volatility and the realized volatility. The premium is the source of the option seller's edge: the option seller sells options at the implied volatility and buys them back at the realized volatility, and the difference is the premium.
The volatility risk premium has been documented in the academic literature for several decades. The premium is largest on short-dated options (less than 30 DTE) and on out-of-the-money options (the wings of a credit spread). The premium is smallest on long-dated options (more than 90 DTE) and on at-the-money options.
The journal's view is that the volatility risk premium is the largest source of the playbook's edges. The journal's short-premium structures (credit spreads, iron condors, iron butterflies) exploit the volatility risk premium by selling options that are more expensive than the realized volatility justifies. The journal's expected value calculation is based on the volatility risk premium: the position's expected value is the volatility risk premium collected over the position's life, minus the realized volatility's cost.
The VIX
The VIX is the Cboe's Volatility Index, which is a measure of the 30-day forward-looking implied volatility of the S&P 500 index. The VIX is computed from the prices of SPX options, and the VIX is the most widely-traded measure of the implied volatility of the US equity market.
The VIX is not directly tradable. The VIX is a measure of the implied volatility, and the VIX is traded indirectly through VIX futures, VIX options, and VIX-tracking exchange-traded products (ETPs). The VIX futures are the most direct way to trade the VIX, and the VIX options are the most direct way to trade the implied volatility.
The VIX is the journal's primary reference for the implied volatility of the broad market. The journal's IV rank calculation is based on the VIX's 52-week range, and the journal's volatility regime rules are based on the VIX's level. The journal does not trade VIX futures or VIX options directly, but the journal uses the VIX as a reference for the implied volatility of the SPX options that the journal trades.
The relationship between VIX and realized volatility
The VIX is the market's estimate of the 30-day forward-looking realized volatility of the S&P 500. The VIX is not the realized volatility; the VIX is the market's estimate of the realized volatility. The relationship between the VIX and the realized volatility is the basis for the volatility risk premium.
The VIX is typically higher than the realized volatility. The difference is the volatility risk premium, and the difference is the source of the option seller's edge. The VIX is also more volatile than the realized volatility: the VIX moves around more than the realized volatility, and the VIX is more sensitive to changes in the market's expectations.
The journal's view is that the VIX is a useful reference for the implied volatility, but the VIX is not the realized volatility. The journal's expected value calculation is based on the realized volatility, not the VIX, and the journal's edge is the difference between the VIX and the realized volatility.
The journal's use of the volatility structure
The journal uses the volatility structure in three ways:
1. The IV rank signal. The IV rank is the VIX's position in its 52-week range. The journal's IV rank signal is the basis for the IV-regime rules: the journal sells premium when the IV rank is high (>50) and buys premium when the IV rank is low (<25).
2. The volatility risk premium edge. The journal's short-premium structures exploit the volatility risk premium by selling options at the implied volatility. The journal's expected value calculation is based on the realized volatility, and the difference between the implied and realized volatility is the source of the position's expected value.
3. The volatility skew signal. The volatility skew is the shape of the implied volatility across strikes. The journal uses the skew to identify the strikes where the implied volatility is relatively high (the wings of the smile) and the strikes where the implied volatility is relatively low (the body of the smile). The journal's strike selection rules are based on the skew.
The journal's view is that the volatility structure is the source of the playbook's edges. The volatility structure is a persistent feature of the options market, and the volatility structure is the basis for the journal's expected value calculation. The journal's process discipline is the mechanism by which the volatility structure is monitored and the playbook's rules are revised.