Implied Volatility vs. Forecasted Volatility

B

Bond James

When I say 'implied volatility', I'm referring to the volatility obtained from observed market prices. There already is a market, someone else (possibly lots of them) have already quoted their estimate of the option prices and all you need to do is take that price and reverse-engineer the essential part of the work of valuating an option: find out what volatility they used.

This is what every textbook of option pricing tells you and 99% of them avoid the uncomfortable question: what was first, the chicken or the egg? They're all about 'the market is always right', what's the martingale measure? (The market one, etc).

My strong opinion at this point is that "in the beginning there was volatility" :) I'm starting to not care what the market thinks. 99% of the market seems to be formed by followers who just take for good what the 1% calculates. Because there must be a calculation and it's all about forecasting the future (i.e. not an exact science), which leaves a lot of room for diverging (and eventually correct) ideas.

I'm working on a software which does just that, so question: do you know of such a feature already largely available (the usual web app), or at least available to niche markets (in-house hedge fund stuff)?
 
Bond James said:
When I say 'implied volatility', I'm referring to the volatility obtained from observed market prices. There already is a market, someone else (possibly lots of them) have already quoted their estimate of the option prices and all you need to do is take that price and reverse-engineer the essential part of the work of valuating an option: find out what volatility they used.

This is what every textbook of option pricing tells you and 99% of them avoid the uncomfortable question: what was first, the chicken or the egg? They're all about 'the market is always right', what's the martingale measure? (The market one, etc).

My strong opinion at this point is that "in the beginning there was volatility" :) I'm starting to not care what the market thinks. 99% of the market seems to be formed by followers who just take for good what the 1% calculates. Because there must be a calculation and it's all about forecasting the future (i.e. not an exact science), which leaves a lot of room for diverging (and eventually correct) ideas.

I'm working on a software which does just that, so question: do you know of such a feature already largely available (the usual web app), or at least available to niche markets (in-house hedge fund stuff)?
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Option prices are driven by supply and demand for options. Implied vol backed out from that. So it's less about a calculation, or a forecast, and more about the whims of the option market . That's why if you use the simplest possible forecast (realised vol will remain where it is now) you'll usually be short vol (since there is more demand for gamma), and usually make money (at the cost of nasty, negative skew). Be a bit smarter about forecasting, and you can make a little bit more money again. Things that go into a predictive vol model would be: the trend of the underlying asset, intraday price movements, current level of realised vol versus a long run average.

GAT
(used to be an options trader for an investment bank)
 
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