If you were able to see ahead of time the next 5 days realized volatility or the next 5 days of implied volatility, which would you pick? We think realized volatility has more value than implied!
We have researched and designed a way to calculate realized volatility that does not rely directly on log returns. Instead, the variance is proportional to the number of barrier crossings observed over a given time window with a portfolio that rebalances every fixed percentage change, up or down, in the underlying price. For example, 5 rehedges within a 183 minute period look-back window and a limit order ladder with 0.15% price separation yields roughly an 18.0% realized volatility.
This new method of estimation computes a realized volatility based on P&L from a constant gamma position. It is a more direct measure of P&L as opposed to stats from a lognormal returns assumption. While more testing is needed to understand and refine the model’s performance, we believe it can be considered better than other statistical realized volatility measures such as Close-Close, Rogers-Satchell and estimators based on log returns. Percentage change measures the relative change in a price over a specified period. In contrast, ‘Gamma Capture’ is based on the number of up/down barrier crossings. It is stable and therefore a more accurate and unbiased estimator, especially during extreme events that lead to jumps in the underlying asset.
We call our method “Gamma Capture” Realized Volatility.
What is realized volatility?
Implied volatility is what you pay. It is contained and reflected in an option's price. On the other hand, realized volatility is what you get – it is the historical performance in the underlying market. Is the true measure of fluctuations in the past.
Similarly, futures prices are based on expected pricing trends for an upcoming delivery. The spot or cash price is the value of the commodity or index when it is ready for delivery.
One can consider the implied volatility as the forward looking prediction of an option price, while the realized volatility is the current underlying asset price.
Why is realized volatility an important measure?
Optimize Options P&L: Delta hedge options to capture the difference between realized and implied volatility. Profit/Loss depends on the difference between those two measures.
Trade Signals: Set triggers to buy or sell options based on the difference implied and realized volatility.
Forecasting: Input into prediction algorithms for forward realized and implied volatility.
Risk Management: Calculate intra-day VAR.
Trade Timing: Know at what time during the trading day to enter or exit a trade.
Portfolio Re-balancing: Optimize the risk-return tradeoff in portfolios. Re-balance book based on Sharpe Ratio.
Realized volatility plays an important role in asset pricing and risk management. For many financial market practitioners and regulators, it is important to obtain accurate volatility forecasts. ‘Gamma Capture’ is an alternative measure to the traditional realized volatility calculations.
For further information please contact: rob.navin@realtimerisksystems.com
DISCLAIMER
All Options Tree AI materials, information, and presentations are for educational purposes only and should not be considered specific investment advice nor recommendations. Futures, foreign currency and options trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing one's financial security or lifestyle. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading.