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)
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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
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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
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Several historical volatilities exist, depending on the past time horizon which is considered
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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
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The principle of this estimate is based on the general theory of valuation of options, which links implicit volatility to the price of options
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Several implicit volatilities exist, depending on the future time horizon which is considered
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The graph shows the values of S&P 500 implicit and historical volatilities during years 2011 to 2014:
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​​​​​​​​​​​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