Volatility analysis of the price

series
Hey there, Protraders!
Certainly, most traders have heard about such a notion as “volatile market” or “volatility”.
This term is used in almost all technical and fundamental reviews of the various markets
(Forex, stocks, and commodities markets), a lot of research papers has written on the
subject of analysis and "predictions" of volatility. In this article we'll get acquainted with this
notion closer, consider its types, and also basic indicators which allow measuring the
current level of volatility of the price series.

Let's start in order, that is, with a definition. Volatility – is a statistical measure that
characterizes the price variability of the traded instrument. This is a fairly simple definition
at first glance, hides behind itself a lot of mathematical and statistical nuances. Several
charts are presented as an example, on which periods of high and low price volatility are
marked with red (high) and green (low volatility).
There are several types of volatility:
1. Historical volatility is calculated on the base of historical price data, i.e. reflects
information about past character of the asset movement. This type of volatility
includes a wide range of technical indicators, which will be discussed below.
2. Implied volatility (or "expected" or "imputed") is calculated on the base of the prices
of derivatives (options). In fact, this type reflects future price deviations or expected
risks.
3. Historical implied volatility – is a history of predictions for expected volatility which
often averaged for 30, 60, 90, 180 days.

The concept of historical volatility

In the classic sense, the historical volatility is determined by the following formula:

where:

– standard deviation of the asset prices, i.e. measure of the sweeping movement;

– price of the i-th value (here can be one of the four bar prices);

– bringing the volatility indicator to the specified period (most often to the annual
value).

Generally, the standard deviation is calculated either in absolute values, i.e. in the prices of
the specific asset, or relative (%). The value of volatility allows assessing the riskiness of
the asset based on the different factors:

1. Liquidity – the lower the asset liquidity, the higher the volatility, since the amount
of people willing to buy or sell the asset is less. For example: if to consider the
commodity market, then orange juice is much more volatile than the market for
cotton. I.e. this instrument is subjected to a sharp surge in prices. If to consider the
equities, then less liquid equities are also prone to such outbursts, because a major
player that comes again can effortlessly "inflate" the prices.
 2. The release of important reports – usually the volatility is sharply increased after
the release of important reports, such as, change of the Fed interest rate, the
change in the unemployment rate, quarterly reports about company’s profits, as well
as data on oil and other.
3. The economic situation in a particular country – the higher the uncertainty in
the political and economic life of the country, the more risky the investments will be.

The main technical indicators of the

volatility
Quite often, the market uses the phrases "intraday volatility of the asset" or "within the
daily volatility". I.e. is intuitive, that is meant the change or scatter of the trading price
range on some value during the day. ATR (Average true range) is one of such technical
indicators that can show the scatter in prices. The basis for calculating the ATR is the
averaging of the price range for the last n periods for a maximum of three criteria:
The averaging of the obtained values by default in the “Protrader” terminal is set into 14
(depending on the used time frame), herewith the user can choose the period, as well as
the method of averaging (simple, exponential, linear weighted and etc.)

After setting all the parameters, the task for the trader is to use indicators in the trading
system. It should be noted that this indicator does not allow predicting the future course of
prices, but it gives a benchmark for setting the level of take-profit and stop-loss.

For example, let’s set the period of indicator in “5” on the day chart. It is easy to note, the
change of the cyclicity of the underlier price, on the basis of which we can conclude about
return to the average value, and also set some limits of the price scatter within the selected
period (month, quarter, year, etc.).
If we hold the analysis of the series by days of the week, then we can identify the most
active days, where the sweep of the movement is wider than in other days. The same rule
can be applied to the analysis of the series intraday by defining the most volatile hours of
the trading.

Another indicator of the volatility analysis is Bollinger Bandswhich is represented in the

form of three moving average lines. The central line is typical moving average (type is
chosen by the user; by default the simple type of smoothing is set). The other two lines are
the same moving averages, but remote from the central on N standard deviations.
Every trader individually selects the parameters for each instrument, th e time frame, as
well as own style of the trading. As for the volatility, the signal of this indicator is quite
simple – the smaller the width of the channel, the lower the volatility. In order to
understand how narrow the channel is, it is necessary to check on the historical data the
average width of the channel for the quarter, year, to assess the average length of the
trend after breaking through this channel. As an example, this indicator can be used for the
breakdown systems of exit from the flat, or vice versa, for return to the average moving.

The concept of the implied volatility

The next type of volatility – "implied" or "expected", reflects the mood of the participants to
the possible asset movement in near time (usually on the lifetime of the option contract).
As already mentioned, this type is used for the assessment of the derivatives (options).

For example: the option desk on Futures E-mini S&P500 from the “Protrader” terminal is
presented below. The nearest strikes to the current price of the futures (2054.75) and
current values of the volatility for these strikes are marked as yellow rectangles.
Substituting these values into the Black-Scholes formula (you can use other models), we
obtain the current option prices. Currently, the area of research for finding the implied
volatility and search of a better option pricing model has become very popular in the
quantitative finance.
Professional option traders often talk about option prices in terms of volatility, since the
portfolio can be often hedged (the so-called delta-neutral strategy), that is why it is very
important. Typically, such traders trade the volatility change, herewith the change in the
underlier prices is virtually ignored. For example, the cost of XYZ is $110, Call option price
is $2.5, and the implied volatility is 22%. After some time, the equity price grew to $113,
the option also increased in the price to $3.1, and the volatility decreased to 19%. Despite
the fact that the option in the second case rose in price, for the delta-neutral portfolio is
more important that volatility has decreased.

The concept of “volatility smile” is often used in the option trading, which is calculated for
all options of the specific series for one underlier. It is believed that if there is a volatility
skew to one of the option sides (Call or Put), the participants assess this side as riskier. For
example, two charts of volatility, separately for Call-options and for Put-options are
presented below. Asymmetry of the volatility tails on Put options is clearly visible, i.e., it is
higher than on Call options. Such an effect on indices and equities market is associated with
the fear of a strong collapse; therefore, many equities traders stand in long positions, and
hedge the risks using Put options.
To summarize, it is important to note the joint use of all volatility types, since major players
(banks, hedge funds, institutional investors) often work simultaneously on the spot market
and on the options market. For them, the volatility is the same asset, as any stock or
futures.