Using Realized Volatility to Forecast Implied Volatility

Implied volatility is a measure of the expected fluctuations in a security's price. It is used by options traders to gauge the market's expectations for the future volatility of the underlying security. A higher implied volatility means that the market is expecting a greater price movement, while a lower implied volatility indicates that the market is expecting a smaller price movement.

Forecasting implied volatility is important for options traders because it can help them to anticipate the size of future price movements. This information can be used to make informed decisions about when to enter and exit trades, as well as how to adjust their trading strategies. It also helps traders to assess whether the options are under- or overpriced.

There are a number of different techniques that can be used to forecast implied volatility. Reference [1] examined the use of realized volatility to forecast future implied volatility for pricing, trading, and hedging in the S&P 500 index options market,

In this article we examine the incremental economic value of using RV in combination with option IV to forecast future IV for out-of-sample option pricing, trading, and hedging in the SPX options market. Based on a comprehensive out-of-sample analysis, we find that historical RV forecasts retain statistical superiority in the encompassing regressions and out-of-sample pricing tests, but do not have incremental economic value in option trading and hedging. This suggests that RV, which has significant economic value in volatility timing in asset-allocation decisions in the equity and bond markets, may not yield similar economic benefits in the context of SPX options markets in the presence of transaction costs.

In short, the use of realized volatility, in combination with implied volatility, resulted in superior forecasting performance. However, the predictive power of realized volatility did not lead to trading profits.

Does the latter point imply that it’s not useful to try to forecast implied volatility for options trading? Let us know what you think.

References

[1] WH Chan, R Jha and M Kalimipalli, The economic value of using realized volatility in forecasting future implied volatility, The Journal of Financial Research • Vol. XXXII, No. 3, Pages 231–259, Fall 2009

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