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Implied Volatility is Often Overstated Relative to Realized Volatility  Thumbnail

Implied Volatility is Often Overstated Relative to Realized Volatility

Volatility measures the frequency and magnitude of price movements, both up and down, that a stock, bond, commodity, or currency market experiences over time.

The more dramatic the price swings, the fast and wider prices spread out, the higher the level of realized volatility.

Volatility can be measured using actual historical price changes (realized volatility) or it can be a measure of expected future volatility that is implied by option prices.

The Cboe Implied VIX Index is a measure of expected future "implied" volatility.

The Cboe® Realized Volatility Index  is designed to indicate the magnitude of actual realized daily price movements by measuring the annualized standard deviation in the daily price return of an underlying over a specific period.

Empirical observations show implied volatility is routinely overstated relative to the actual realized volatility that materializes in the market.

We can see this observation in the chart below. The red line is implied expected vol, and the black line is realized actual vol. 

Clearly the implied vol is more volatility itself than the actual move.

Why does it matter?

When implied volatility is less than realized vol, it signals it's a relatively better value to buy implied volatility. 

When implied volatility is higher than realized vol, it signals a relatively better deal to sell implied volatility. 

It's what market makers do, as well as successful volatility traders. 

Mike Shell is the founder, President, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of Asymmetry® Managed Portfolios.  Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies. Shell Capital provides investment advice and portfolio management to clients with separate accounts at Goldman Sachs Advisor Solutions with an investment management agreement. The observations shared on this website are for general information only and should not be construed as investment advice to buy or sell any security. This information does not suggest in any way that any graph, chart, or formula offered can solely guide an investor as to which securities to buy or sell, or when to buy or sell them. Securities reflected are not intended to represent any client holdings or recommendations made by the firm. In the event any past specific recommendations are referred to inadvertently, a list of all recommendations made by the company within at least the prior one-year period may be furnished upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities on the list. Any opinions expressed may change as subsequent conditions change. Please do not make any investment decisions based on such information, as it is not individualized advice and is subject to change without notice. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but are not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. If this website contains information regarding Options Trading, please read the Characteristics & Risks of Standardized Options, also known as the options disclosure document (ODD). Options involve risk and are not suitable for all investors. The views and opinions expressed in Asymmetry® Observations and Asymmetric Investment Returns are those of the authors and do not necessarily reflect the position of Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.