Implied volatility is a crystal ball that allows market participants to see far past current prices.
Implied Volatility: The Wisdom of the Crowd
Financial markets purely embody the actions of buyers and sellers expressing their opinion on the path of least resistance of prices with their pocketbooks.
In 2004, author James Surowiecki authored a classic, The Wisdom of Crowds: Why the Many Are Smarter Than the Few and How Collective Wisdom Shares Business, Economies, Societies, and Nations. The work explored how a group of people make better decisions than any “expert.” The takeaway is that large groups are smarter than an elite few, no matter how brilliant, and are better at solving problems, fostering innovation, coming to wise decisions, and even predicting the future.
Financial markets purely embody Surowiecki’s work as the price of any asset results from the actions of buyers and sellers that express their opinion on the path of least resistance of prices with their pocketbooks. The current price is always the correct price because it is the level where buyers and sellers meet in a transparent marketplace.
Meanwhile, put and call options are derivatives that are price insurance. Buyers of options can insure prices at specific or strike prices and pay a premium. While option buyers are insured, option sellers act as insurance providers, collecting premiums to offset the risk of performance. The primary ingredient in option pricing is implied volatility, or the price variance the market projects will occur during the life of put and call options. Implied volatility is another example of James Surowiecki’s wisdom or crowd theory.
Historical Volatility – The Past
- A statistical measure of the dispersion of returns for a given asset over a period.
- Historical volatility is price variance over time.
- The past is never a guarantee of the future, but history tends to repeat.
Implied Volatility – The Future
- The market’s consensus forecast of future price variance.
- Implied volatility is the primary factor for put and call option prices.
- Implied volatility changes with market changes.
Implied volatility is a barometer of the crowd’s wisdom
- A constantly changing measure of the overall market’s opinion of future price variance.
- Implied volatility embodies James Surowiecki’s Wisdom of Crowds
- Bids and offers for put and call options determine the current implied volatility level for assets.
Applications beyond option pricing
- Implied volatility tells us if the market’s consensus opinion is for a future narrow or wide price range.
- Implied volatility is a metric that can empirically establish the current market’s opinion of the range from high to low for a period.
- High implied volatility tends to predict or reflect fear where market participants buy options, which are price insurance.
- Low implied volatility often predicts or reflects greed, where market participants sell options to collect premiums and enhance returns on existing risk positions.
- Implied volatility is a living, breathing consensus metric that signals the overall market’s fear and greed levels.
The subjectivity of experts – Objectivity of data and statistics
- Statistics are objective, but objective data only reflects historical factors.
- Experts offer opinions, but they are subjective educated guesses about the future.
- Historical volatility is objective as it reflects only the past.
- Implied volatility is subjective and is a function of the crowd’s wisdom.
- The crowd’s wisdom establishes the current market price, which is always the correct price at that time.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!