April – May Update: “Viewpoint” for Volatility
Hi, just a quick entry this time, quoted from my comments to Hedge Fund Review:
First a close to close (daily) approach to calculating realized volatility:
Volt,n =the realized volatility of the Index for an n number of trading days (including t day) as of the t day
Et =Closing value of the Index on t day
n =Number of days for which volatility is calculated
Historical volatility data are calculated on a daily basis for 21, 42, 63, 126, and 252 trading days
Any investor interested in making a play in the derivatives markets should first acknowledge that Volatility, the most enigmatic component which affects derivatives prices is just a number, a man made synthetic construct inserted into the models to make them resemble the instinctive fluctuations in nature more closely, but not precisely.
The Black Scholes Model, later with the much favored skew amendment, is still in use today as a standard tool so competing marketmakers and exchanges can unanimously agree on a reference model and proceed to quote their exchange traded products tighter and tighter to invite further investor interest. Driven by competitiveness and this kind of synthetic understanding implied between market makers, the exchange traded derivatives markets have taken a life of their own almost independent of what the price action indicates in terms of real life expectation. In other words, it should be lucid to any participant that regardless of the underlying reasons for price movement, under all circumstances derivatives pricing and its essential variable volatility are driven by the positions of the books of the marketmakers, and thus indirectly the investor interest that initiates these positions.
The opportunity for arbitrage for the brilliant investor then lies in the discrepancy between the volatility indicated by the price of the derivative vs the real life volatility, or what I call natural volatility, which is the topic of another entry.