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What Is Stock Market Volatility?
What Is Stock Market Volatility?
Published: 2011/12/29
Channel: Option Alpha
Understanding Market Volatility and Trading Volatile Days
Understanding Market Volatility and Trading Volatile Days
Published: 2012/10/10
Channel: Sasha Evdakov
Implied volatility | Finance & Capital Markets | Khan Academy
Implied volatility | Finance & Capital Markets | Khan Academy
Published: 2013/07/29
Channel: Khan Academy
FRM: Intro to Quant Finance: Volatility
FRM: Intro to Quant Finance: Volatility
Published: 2007/12/21
Channel: Bionic Turtle
What Is Volatility?   The Wealth Academy
What Is Volatility? The Wealth Academy
Published: 2013/06/19
Channel: ValentineVenturesLLC
Financial Volatility at the Edge of Crisis | A Conversation with Christopher Cole
Financial Volatility at the Edge of Crisis | A Conversation with Christopher Cole
Published: 2017/06/16
Channel: Hidden Forces
How to calculate Volatility using expected returns
How to calculate Volatility using expected returns
Published: 2016/01/18
Channel: Edspira
Volatility and the Risk Premium of a Single Stock
Volatility and the Risk Premium of a Single Stock
Published: 2016/01/18
Channel: Edspira
Billionaire Investor Carl Icahn On Market Volatility | CNBC
Billionaire Investor Carl Icahn On Market Volatility | CNBC
Published: 2018/02/06
Channel: CNBC
FRM: Volatility approaches
FRM: Volatility approaches
Published: 2008/02/05
Channel: Bionic Turtle
9. Volatility Modeling
9. Volatility Modeling
Published: 2015/01/06
Channel: MIT OpenCourseWare
The Volatility Index (VIX) Explained
The Volatility Index (VIX) Explained
Published: 2011/12/29
Channel: Option Alpha
What is XIV & How Does it Work? | Volatility Trading
What is XIV & How Does it Work? | Volatility Trading
Published: 2017/03/29
Channel: projectoption
1. Finance, Growth, and Volatility
1. Finance, Growth, and Volatility
Published: 2014/03/06
Channel: MIT OpenCourseWare
FRM: Implied volatility
FRM: Implied volatility
Published: 2008/02/06
Channel: Bionic Turtle
Historical vs. Implied Options Volatility
Historical vs. Implied Options Volatility
Published: 2016/05/05
Channel: Option Alpha
How to Find the Historical Volatility (Standard Deviation) of an Asset
How to Find the Historical Volatility (Standard Deviation) of an Asset
Published: 2013/09/22
Channel: InformedTrades
Adventures In Finance Episode 13 - What Lies Beneath: Volatility in a Peaceful World
Adventures In Finance Episode 13 - What Lies Beneath: Volatility in a Peaceful World
Published: 2017/05/05
Channel: Real Vision
What is Volatility? - Tactics for Trading in High Volatility Markets
What is Volatility? - Tactics for Trading in High Volatility Markets
Published: 2014/02/07
Channel: Trading Tips
Econometrics for Finance - S6 - Volatility Models
Econometrics for Finance - S6 - Volatility Models
Published: 2015/04/14
Channel: UG BSU Elearning and PBL
FRM: Forecast volatility with GARCH(1,1)
FRM: Forecast volatility with GARCH(1,1)
Published: 2008/02/13
Channel: Bionic Turtle
Finance with Excel: Two Axis Stock Price and Volatility Graph
Finance with Excel: Two Axis Stock Price and Volatility Graph
Published: 2015/05/19
Channel: Peter Dixon
FRM: GARCH(1,1) to estimate volatility
FRM: GARCH(1,1) to estimate volatility
Published: 2008/02/12
Channel: Bionic Turtle
Paul Wilmott on Quantitative Finance, Chapter 12, How to arbitrage volatility
Paul Wilmott on Quantitative Finance, Chapter 12, How to arbitrage volatility
Published: 2011/02/18
Channel: Nathan Whitehead
FRM: Implied volatility smile
FRM: Implied volatility smile
Published: 2010/06/18
Channel: Bionic Turtle
The volatility paradox
The volatility paradox
Published: 2017/03/10
Channel: Financial Times
The Key Takeaways From Market Volatility
The Key Takeaways From Market Volatility
Published: 2018/02/16
Channel: Bloomberg Markets and Finance
5. Corporate Finance Essentials. Volatility
5. Corporate Finance Essentials. Volatility
Published: 2018/06/28
Channel: koniec19
Constructing an Implied Volatility Surface 1
Constructing an Implied Volatility Surface 1
Published: 2015/10/23
Channel: Brian Byrne
Open Yale Course:Financial Markets 06. Efficient Markets vs. Excess Volatility
Open Yale Course:Financial Markets 06. Efficient Markets vs. Excess Volatility
Published: 2011/01/01
Channel: FriendML
Striving in Business & Finance Despite Market Volatility!
Striving in Business & Finance Despite Market Volatility!
Published: 2018/02/06
Channel: Rick Wallace PhD, PsyD
Finance Talk: Increased volatility – New Fed Chair – Spike in bond yields
Finance Talk: Increased volatility – New Fed Chair – Spike in bond yields
Published: 2018/02/06
Channel: Julius Baer
Standard Deviation - Volatility
Standard Deviation - Volatility
Published: 2013/08/26
Channel: StockGoodies Chart-School
ProShares Makes Volatility Products Less Risky
ProShares Makes Volatility Products Less Risky
Published: 2018/02/27
Channel: Bloomberg Markets and Finance
Adventures in Finance Ep 55: The Storm After The Calm - Is Market Volatility Back?
Adventures in Finance Ep 55: The Storm After The Calm - Is Market Volatility Back?
Published: 2018/03/03
Channel: Real Vision
Market Volatility and Financial Planning
Market Volatility and Financial Planning
Published: 2012/09/14
Channel: AOL Finance
Utilizing Topographic Finance to Understand Volatility - Working Paper
Utilizing Topographic Finance to Understand Volatility - Working Paper
Published: 2015/04/05
Channel: Paul Cottrell
The Difference Between Beta & Implied Volatility : Business & Personal Finance
The Difference Between Beta & Implied Volatility : Business & Personal Finance
Published: 2012/10/23
Channel: ehowfinance
Will volatility return to the markets in 2015? | World Finance Videos
Will volatility return to the markets in 2015? | World Finance Videos
Published: 2014/12/18
Channel: worldfinancevideos
Quantum Artificial Financial Market - Risk and Volatility
Quantum Artificial Financial Market - Risk and Volatility
Published: 2012/05/14
Channel: Carlos Pedro Gonçalves
Allianz
Allianz's Mahajan Sees More Volatility in 2018
Published: 2018/02/16
Channel: Bloomberg Markets and Finance
Stock Volatility and Technical Indicators | HINDI
Stock Volatility and Technical Indicators | HINDI
Published: 2017/12/21
Channel: Nitin Bhatia
Institute of International Finance on Banking, Volatility
Institute of International Finance on Banking, Volatility
Published: 2018/02/23
Channel: Bloomberg Markets and Finance
Finance Expert Warns Public of Volatility of Bitcoin Investment
Finance Expert Warns Public of Volatility of Bitcoin Investment
Published: 2018/01/31
Channel: Financial Prediction
Credit Suisse CEO Thiam on Trading Revenue and Equities Volatility
Credit Suisse CEO Thiam on Trading Revenue and Equities Volatility
Published: 2018/02/14
Channel: Bloomberg Markets and Finance
Inside Volatility Filtering Secrets of the Skew Wiley Finance
Inside Volatility Filtering Secrets of the Skew Wiley Finance
Published: 2016/03/17
Channel: Janet Grover
Build your own Financial Planning Spreadsheet (part 3) - adding volatility of returns
Build your own Financial Planning Spreadsheet (part 3) - adding volatility of returns
Published: 2017/04/18
Channel: Lars Kroijer
Volatility (finance)
Volatility (finance)
Published: 2014/08/28
Channel: Audiopedia
What is autocorrelation (and how does it impact scaled volatility)? FRM T1-4
What is autocorrelation (and how does it impact scaled volatility)? FRM T1-4
Published: 2017/10/12
Channel: Bionic Turtle
The art of term structure models volatility and distribution
The art of term structure models volatility and distribution
Published: 2017/08/08
Channel: Vamsidhar Ambatipudi
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WIKIPEDIA ARTICLE

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The VIX

In finance, volatility (symbol σ) is the degree of variation of a trading price series over time as measured by the standard deviation of logarithmic returns.

Historic volatility measures a time series of past market prices. Implied volatility looks forward in time, being derived from the market price of a market-traded derivative (in particular, an option).

Volatility terminology[edit]

Volatility as described here refers to the actual volatility, more specifically:

  • actual current volatility of a financial instrument for a specified period (for example 30 days or 90 days), based on historical prices over the specified period with the last observation the most recent price.
  • actual historical volatility which refers to the volatility of a financial instrument over a specified period but with the last observation on a date in the past
    • near synonymous is realized volatility, the square root of the realized variance, in turn calculated using the sum of squared returns divided by the number of observations.
  • actual future volatility which refers to the volatility of a financial instrument over a specified period starting at the current time and ending at a future date (normally the expiry date of an option)

Now turning to implied volatility, we have:

  • historical implied volatility which refers to the implied volatility observed from historical prices of the financial instrument (normally options)
  • current implied volatility which refers to the implied volatility observed from current prices of the financial instrument
  • future implied volatility which refers to the implied volatility observed from future prices of the financial instrument

For a financial instrument whose price follows a Gaussian random walk, or Wiener process, the width of the distribution increases as time increases. This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other out, so the most likely deviation after twice the time will not be twice the distance from zero.

Since observed price changes do not follow Gaussian distributions, others such as the Lévy distribution are often used.[1] These can capture attributes such as "fat tails". Volatility is a statistical measure of dispersion around the average of any random variable such as market parameters etc.

Mathematical definition[edit]

For any fund that evolves randomly with time, the square of volatility is the variance of the sum of infinitely many instantaneous rates of return, each taken over the nonoverlapping, infinitesimal periods that make up a single unit of time.

Thus, "annualized" volatility σannually is the standard deviation of an instrument's yearly logarithmic returns.[2]

The generalized volatility σT for time horizon T in years is expressed as:

Therefore, if the daily logarithmic returns of a stock have a standard deviation of σdaily and the time period of returns is P in trading days, the annualized volatility is

A common assumption is that P = 252 trading days in any given year. Then, if σdaily = 0.01, the annualized volatility is

The monthly volatility (i.e., T = 1/12 of a year or P = 252/12 = 21 trading days) would be

The formulas used above to convert returns or volatility measures from one time period to another assume a particular underlying model or process. These formulas are accurate extrapolations of a random walk, or Wiener process, whose steps have finite variance. However, more generally, for natural stochastic processes, the precise relationship between volatility measures for different time periods is more complicated. Some use the Lévy stability exponent α to extrapolate natural processes:

If α = 2 you get the Wiener process scaling relation, but some people believe α < 2 for financial activities such as stocks, indexes and so on. This was discovered by Benoît Mandelbrot, who looked at cotton prices and found that they followed a Lévy alpha-stable distribution with α = 1.7. (See New Scientist, 19 April 1997.)

Volatility origin[edit]

Much research has been devoted to modeling and forecasting the volatility of financial returns, and yet few theoretical models explain how volatility comes to exist in the first place.

Roll (1984) shows that volatility is affected by market microstructure.[3] Glosten and Milgrom (1985) shows that at least one source of volatility can be explained by the liquidity provision process. When market makers infer the possibility of adverse selection, they adjust their trading ranges, which in turn increases the band of price oscillation.[4]

Volatility for investors[edit]

Investors care about volatility for at least eight reasons:

  1. The wider the swings in an investment's price, the harder emotionally it is to not worry;
  2. Price volatility of a trading instrument can define position sizing in a portfolio;
  3. When certain cash flows from selling a security are needed at a specific future date, higher volatility means a greater chance of a shortfall;
  4. Higher volatility of returns while saving for retirement results in a wider distribution of possible final portfolio values;
  5. Higher volatility of return when retired gives withdrawals a larger permanent impact on the portfolio's value;
  6. Price volatility presents opportunities to buy assets cheaply and sell when overpriced;
  7. Portfolio volatility has a negative impact on the compound annual growth rate (CAGR) of that portfolio
  8. Volatility affects pricing of options, being a parameter of the Black–Scholes model.

In today's markets, it is also possible to trade volatility directly, through the use of derivative securities such as options and variance swaps. See Volatility arbitrage.

Volatility versus direction[edit]

Volatility does not measure the direction of price changes, merely their dispersion. This is because when calculating standard deviation (or variance), all differences are squared, so that negative and positive differences are combined into one quantity. Two instruments with different volatilities may have the same expected return, but the instrument with higher volatility will have larger swings in values over a given period of time.

For example, a lower volatility stock may have an expected (average) return of 7%, with annual volatility of 5%. This would indicate returns from approximately negative 3% to positive 17% most of the time (19 times out of 20, or 95% via a two standard deviation rule). A higher volatility stock, with the same expected return of 7% but with annual volatility of 20%, would indicate returns from approximately negative 33% to positive 47% most of the time (19 times out of 20, or 95%). These estimates assume a normal distribution; in reality stocks are found to be leptokurtotic.

Volatility over time[edit]

Although the Black Scholes equation assumes predictable constant volatility, this is not observed in real markets, and amongst the models are Emanuel Derman and Iraj Kani's[5] and Bruno Dupire's local volatility, Poisson process where volatility jumps to new levels with a predictable frequency, and the increasingly popular Heston model of stochastic volatility.[6]

It is common knowledge that types of assets experience periods of high and low volatility. That is, during some periods, prices go up and down quickly, while during other times they barely move at all.[7]

Periods when prices fall quickly (a crash) are often followed by prices going down even more, or going up by an unusual amount. Also, a time when prices rise quickly (a possible bubble) may often be followed by prices going up even more, or going down by an unusual amount.

Most typically, extreme movements do not appear 'out of nowhere'; they are presaged by larger movements than usual. This is termed autoregressive conditional heteroskedasticity. Whether such large movements have the same direction, or the opposite, is more difficult to say. And an increase in volatility does not always presage a further increase—the volatility may simply go back down again.

The risk parity weighted volatility of the three assets Gold, Treasury bonds and Nasdaq (Worldvolatility.com) acting as proxy for the Marketportfolio seems to have a low point at 4% after turning upwards for the 8th time since 1974 at this reading in the summer of 2014.worldvolatility.com

Alternative measures of volatility[edit]

Some authors point out that realized volatility and implied volatility are backward and forward looking measures, and do not reflect current volatility. To address that issue an alternative, ensemble measure of volatility was suggested.[8] This measure is defined as the standard deviation of ensemble returns instead instead of time series of returns.

Implied volatility parametrisation[edit]

There exist several known parametrisation of the implied volatility surface, Schonbucher, SVI and gSVI.[9]

Crude volatility estimation[edit]

Using a simplification of the above formula it is possible to estimate annualized volatility based solely on approximate observations. Suppose you notice that a market price index, which has a current value near 10,000, has moved about 100 points a day, on average, for many days. This would constitute a 1% daily movement, up or down.

To annualize this, you can use the "rule of 16", that is, multiply by 16 to get 16% as the annual volatility. The rationale for this is that 16 is the square root of 256, which is approximately the number of trading days in a year (252). This also uses the fact that the standard deviation of the sum of n independent variables (with equal standard deviations) is √n times the standard deviation of the individual variables.

The average magnitude of the observations is merely an approximation of the standard deviation of the market index. Assuming that the market index daily changes are normally distributed with mean zero and standard deviation σ, the expected value of the magnitude of the observations is √(2/π)σ = 0.798σ. The net effect is that this crude approach underestimates the true volatility by about 20%.

Estimate of compound annual growth rate (CAGR)[edit]

Consider the Taylor series:

Taking only the first two terms one has:

Volatility thus mathematically represents a drag on the CAGR (formalized as the "volatility tax"). Realistically, most financial assets have negative skewness and leptokurtosis, so this formula tends to be over-optimistic. Some people use the formula:

for a rough estimate, where k is an empirical factor (typically five to ten).

Criticisms of volatility forecasting models[edit]

Performance of VIX (left) compared to past volatility (right) as 30-day volatility predictors, for the period of Jan 1990-Sep 2009. Volatility is measured as the standard deviation of S&P500 one-day returns over a month's period. The blue lines indicate linear regressions, resulting in the correlation coefficients r shown. Note that VIX has virtually the same predictive power as past volatility, insofar as the shown correlation coefficients are nearly identical.

Despite the sophisticated composition of most volatility forecasting models, critics claim that their predictive power is similar to that of plain-vanilla measures, such as simple past volatility [10][11] especially out-of-sample, where different data are used to estimate the models and to test them.[12] Other works have agreed, but claim critics failed to correctly implement the more complicated models.[13] Some practitioners and portfolio managers seem to completely ignore or dismiss volatility forecasting models. For example, Nassim Taleb famously titled one of his Journal of Portfolio Management papers "We Don't Quite Know What We are Talking About When We Talk About Volatility".[14] In a similar note, Emanuel Derman expressed his disillusion with the enormous supply of empirical models unsupported by theory.[15] He argues that, while "theories are attempts to uncover the hidden principles underpinning the world around us, as Albert Einstein did with his theory of relativity", we should remember that "models are metaphors – analogies that describe one thing relative to another".

Volatility hedge funds[edit]

Well known hedge fund managers with expertise in trading volatility include Mark Spitznagel and Nassim Nicholas Taleb of Universa Investments, Paul Britton of Capstone Holdings Group,[16] Andrew Feldstein of Blue Mountain Capital Management,[17] and Nelson Saiers from Saiers Capital.[18]

See also[edit]

References[edit]

  1. ^ "Levy distribution". wilmottwiki.com. 
  2. ^ "Calculating Historical Volatility: Step-by-Step Example" (PDF). 14 July 2011. Retrieved 15 July 2011. 
  3. ^ Roll, R. (1984): "A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market", Journal of Finance 39 (4), 1127–1139
  4. ^ Glosten, L. R. and P. R. Milgrom (1985): "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders", Journal of Financial Economics 14 (1), 71–100
  5. ^ Derman, E., Iraj Kani (1994). ""Riding on a Smile." RISK, 7(2) Feb.1994, pp. 139–145, pp. 32–39" (PDF). Risk. Retrieved 2007-06-01. 
  6. ^ "Volatility". wilmottwiki.com. 
  7. ^ "Taking Advantage Of Volatility Spikes With Credit Spreads". 
  8. ^ Sarkissian, Jack (2016). "Express Measurement of Market Volatility Using Ergodicity Concept". 
  9. ^ Babak Mahdavi Damghani & Andrew Kos (2013). "De-arbitraging with a weak smile". Wilmott. http://www.readcube.com/articles/10.1002/wilm.10201?locale=en
  10. ^ Cumby, R.; Figlewski, S.; Hasbrouck, J. (1993). "Forecasting Volatility and Correlations with EGARCH models". Journal of Derivatives. 1 (2): 51–63. doi:10.3905/jod.1993.407877. 
  11. ^ Jorion, P. (1995). "Predicting Volatility in Foreign Exchange Market". Journal of Finance. 50 (2): 507–528. doi:10.1111/j.1540-6261.1995.tb04793.x. JSTOR 2329417. 
  12. ^ Brooks, Chris; Persand, Gita (2003). "Volatility forecasting for risk management". Journal of Forecasting. 22 (1): 1–22. doi:10.1002/for.841. ISSN 1099-131X. 
  13. ^ Andersen, Torben G.; Bollerslev, Tim (1998). "Answering the Skeptics: Yes, Standard Volatility Models Do Provide Accurate Forecasts". International Economic Review. 39 (4): 885–905. JSTOR 2527343. 
  14. ^ Goldstein, Daniel and Taleb, Nassim, (28 March 2007) "We Don't Quite Know What We are Talking About When We Talk About Volatility". Journal of Portfolio Management 33 (4), 2007.
  15. ^ Derman, Emanuel (2011): Models.Behaving.Badly: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life”, Ed. Free Press.
  16. ^ Devasabai, Kris (1 March 2010). "Interview with Paul Britton Founder CEO of Capstone". Hedge Funds Review. Retrieved 26 April 2013. 
  17. ^ Schaefer, Steve (14 February 2013). "Blue Mountain's Andrew Feldstein: Three Ways to Play a More Volatile Steel Industry". Forbes. Retrieved 26 April 2013. 
  18. ^ Creswell, Julie and Louise Story (17 March 2011). "Funds Find Opportunities in Volatility". New York Times. Retrieved 26 April 2013. 

External links[edit]

Further reading[edit]

  1. Bartram, Söhnke M.; Brown, Gregory W.; Stulz, Rene M. (August 2012). "Why Are U.S. Stocks More Volatile?". Journal of Finance. 67 (4): 1329–1370. doi:10.1111/j.1540-6261.2012.01749.x. SSRN 2257549Freely accessible. 

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