The market may believe it's perfectly efficient, but on today's blog, Dr. Data sets the record straight - at least in terms of equity options.

Following up on a recent post covering historical and implied volatility, The Skinny on Options Data Science crew takes a run at the concept of actual volatility (also called realized volatility).

Implied volatility is the number we can reverse-engineer from current option prices to calculate "fair value" for volatility. This is the level of volatility that the market expects will come to pass through the stock's future movement over a given period of time (present through expiration).

The question that Dr. Mike Rechenthin (aka Dr. Data), Tom Sosnoff, and Tony Battista examine on this episode of The Skinny on Options Data Science is related to how successful implied volatility (market volatility) has been in predicting actual volatility.

The research team's hypothesis was that actual stock moves would generally not be as large as those implied by the options market.

The parameters of the study that the team utilized to find a conclusive answer to this question included the following:

  • 30 stocks from the Dow, 12 months of past data
  • Compared implied volatility to actual volatility, 30 days later

The graphic below illustrates the three expected outcomes from such an exercise:

 

The results of the study actually came back exactly as the team expected. In their research, implied volatility overstated actual volatility on 77% of trading days. That meant utilizing strategies that involved selling premium would have been profitable 77% of the time in this set of stocks over the last 12 months because the stock prices didn’t move as much as the volatility predicted.

Depicted below is a "normal" distribution of implied volatility versus the actual performance of implied volatility in this study. As you can see, the difference between the distributions of implied volatility and actual volatility shows that on average, in this study, implied volatility overstated the expected moves of the stocks.

ffectively, Dr. Data, Tom, and Tony have shown that the market isn't always perfectly efficient at pricing risk, especially as it relates to equity options volatility.

We encourage you to watch the entire episode discussed above by following this link.

Additionally, the entire content of library from the Dr. Data series The Skinny on Options Data Science can be accessed by following this link.

Thank you for reading and please leave any feedback on past or future programming below!

Happy trading!