Option traders need to be aware of two types of volatility. The first is realized volatility, the actual volatility of the underlying over the lifetime of the option. We looked at how to measure and forecast this quantity in the previous chapter. The second type of volatility is implied volatility, the volatility input to an option-pricing model that gives the market price of the option. A simple gambling example might make this clear.
Let’s say that we have studied a baseball game. We have examined each side’s hitters and forecast their batting averages, number of walks, and chances of hitting a home run. We have also forecast the performance of the pitchers, and then combined these results to arrive at a forecast for the game. We decide that the Cubs have a 55 percent chance of beating the Cardinals. This is our forecast of the result. It is analogous to an option trader’s forecast of the realized volatility.
Now we find that the bookmakers have the Cubs at even money, so if we bet on them we stand to win $100 for each $100 we wager. This means that they think the Cubs have a 50 percent chance of winning. This is the market’s forecast of the result. It is analogous to an option’s implied volatility.
Neither one of these forecasts are particularly interesting on their own. What is interesting is the relationship between the two. When our opinion is different from that of the rest of the market we have a chance to trade and profit.
THE IMPLIED VOLATILITY ...