Many investors are often curious what is an “appropriate” volatility benchmark. In finance, the best way for us to measure the relative value of volatility is to look at historical or realized volatility. The first step in creating a useful trading signal is to develop a volatility cone. A volatility cone samples the distribution of historical volatility broken out by option tenor. So we sample historical volatility based upon different time periods such as 1 month, 2 months, 6 months, 1 year etc. Once you have the distribution of historical volatility, you can show the relative attractiveness of a certain option’s implied volatility versus the historical distributions for that time period. This might seem confusing, so it is better to provide a visualization.
The cone compresses as we show longer periods of time
What this cone is telling us is that over longer option horizons we should feel comfortable selling anything with an implied volatility greater than 35% and buying anything at an implied volatility in the single digits. What we also see is that there is not a big discrepancy between most of these tenors except for when you get into the tail events. This is mostly due to the law of large numbers where the 30 day percentiles converge towards the longer term percentiles.
This means that for trading purposes a shorter time frame is more useful. In a refinement, let’s look at the last 5 years instead of the last 80.
A much more visible cone shape in 5 years
The last 5 years of data shows us a greater dispersion between tenors. We witnessed 1-month periods of 80% realized volatility while we realized one year periods of just half that. Volatility cones are by all means not perfect indicators as the future is always an unknown, but being able to plot current implied volatility levels against these historical metrics provides one basis for coming up with a trade idea.
