Tuesday, July 14, 2009

Gauging Market Volatility

While many people are aware that the VIX index is a broad measure of market volatility (currently at 25 and nearing 10 month lows), there are further indicators that traders can use to gauge actual volatility in individual stocks.
For example, if we know the volatility ("vol") of the at the money options of a stock, then we can figure out a one standard deviation price change that accompanies this level of volatility. Similarly if we want to check whether the daily price changes reflect the actual current option volatility in the stock we can calculate this as well.

The formula below breaks down the 1 standard deviation price change we would expect from a stock. That is, on 2 out of 3 trading days the price change in the stock should be less than or equal to this amount.

Daily Volatility:
[(% volatility)/(16)]* underlying price = 1 std dev price change

Where 16 is the square root of the approximate number of trading days per year (256)

Utilizing this equation we have a sanity check to see if the option volatility we are buying or selling is accurately reflected and priced in the daily moves we are seeing in the underlying. If the daily moves we observe are greater than what the current volatility is pricing than perhaps the options are relatively cheap. Conversely, if the daily moves are significantly less than what we would expect, buyers may be paying too much for the options.

(Formula taken from Natenberg, Sheldon: Option Volatility and Pricing)

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