Options traders are fixated on volatility, both historical and implied. Equities and futures traders pay lip service to volatility but seldom make it part of their models, save for the occasional Bollinger bands overlaid on charts.
Jeff Augen is an options volatility geek. His book The Volatility Edge in Options Trading (FT Press, 2008) is a thoughtful work for the experienced option trader. Today I’m going to look at the charts Augen uses in his options analysis because I think they might provide a new perspective for developing stock and futures strategies.
We normally look at charts of closing prices. Augen, however, prefers to look at historical volatility charts. Historical volatility is easily programmed in most charting software packages. For instance, in MetaStock the AAPL 20-day historical volatility that I illustrate below is captured by the formula Std(Log(C/Ref(C,-1)),20)*Sqrt(252)*100. Here, like Augen, I’m assuming a 252-day trading year and am calculating volatility for 20 price changes (21 trading days).
(Click on the image to enlarge it.)
Note the difference between volatility as measured by Bollinger bands and historical volatility as used in option calculations. Bollinger bands measure the standard deviation of the stock price; historical volatility measures the standard deviation of the log of the price change.
Okay, you ask, so what’s the point of looking at historical volatility? Augen admits that “volatility alone has limited predictive power.” But, he continues, “certain trends emerge if you view a large number of volatility charts. Most notable is the relationship between high volatility and poor stock performance.” (p. 56)
Larry Connors’ research supports this view. He looked at 11,282 stocks from January 1, 1995 through May 31, 2007. Each day he ranked the 100-day historical volatility of these stocks. He then compared the 252-day performance of the top 20% in terms of volatility versus the 20% with the lowest volatility. The latter outperformed the former by about 2:1 (14.7% vs. 7.3%). And only 42.2% of the high volatility stocks closed higher one year later, as opposed to 74.5% of the low volatility stocks.
Historical volatility might be a worthy filter in developing a trading system. By the way, it’s one of the metrics available on MarketRewind. See, for starters, the free weekly ETF Rewind.
One cautionary note about focusing on historical volatility to the exclusion of implied volatility. There are situations in which there is a major disconnect between historical volatility and implied volatility, usually indicating a significant upcoming event. Take the recent case of Medivation whose late stage Alzheimer’s drug study did not meet its goals. On March 2 the stock closed at 40.25 with a 20-day historical volatility of 41%, admittedly a high figure. (For instance, GOOG’s HV was 17% and WMT’s was 14%.) But options at the 40 strike had an implied volatility of about 269%! And what happened on March 3? The stock cratered, down some 68% to about 13 when I checked during the day.