The Volatility Hedge
What is volatility?
Volatility is a very important concept in finance, in particular because it is used to quantify the prices of options
It is important to differentiate two main but totally different concepts:
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The historical volatility of an underlying asset (for example, the S&P 500 index)
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The implied volatility, also called implicit volatility, of an underlying asset (for example, the S&P 500 index)
These two main concepts are one of the basis of The Volatility Hedge strategy
To know more about volatility
The historical volatility is a statistical calculation of dispersion of historical actual data of the S&P 500 index
This measure is calculated by determining the average deviation from the average price of a financial instrument in the given time period
The principle of this calculation is to take into account the values of S&P 500 index, and to calculate the standard deviation of the average of the day-to-day change
Several historical volatilities exist, depending on the past time horizon which is considered
The implied volatility is an estimate of future volatility of to-be values (for example the S&P 500 index)
This estimate is based on the prices of options, and is calculated by comparing real prices of options to theoretical prices
The principle of this estimate is based on the general theory of valuation of options, which links implicit volatility to the price of options
Several implicit volatilities exist, depending on the future time horizon which is considered
The graph shows the values of S&P 500 implicit and historical volatilities during years 2011 to 2014:
The implicit volatility refers to the VIX (c) Index calculated and provided by the CBOE
More information and detailed materials are available on CBOE website, about that main concept of volatility