What You Don't Know About Volatility Can Hurt You

Shah Gilani

Editor's Note: As one of the traders who was instrumental in creating the precursor to the VIX, we asked Shah to write about the truth behind our understanding of volatility and how it applies to today's volatile markets.

The wild swings we see in the stock market aren't the result of volatility.

Volatility results from the wild swings, not the other way around.

One thing investors don't understand is that the VIX (the CBOE Volatility Index, sometimes called the market's "fear gauge") isn't predictive. It isn't a leading indicator; it isn't telling us what the future holds. It's misleading.

If you didn't know that, chances are you may not understand what's really causing wild market swings.

Here's your quick fix on the VIX and how to avoid falling into the fear gauge's trap...

Back to Volatility Basics

There are two kinds of volatility:

1. Realized volatility
2. Implied volatility

Realized volatility, more often called historical volatility, is a measure of past volatility.

One measure of how things move is standard deviation, or how far from the "mean" (its average) something moves. A one standard deviation move is tame, a two standard deviation move is less so, and so on. Historical volatility is the average of how many standard deviations something moves (in either direction) over a period of time.

We know how volatile something has been, like a stock or the stock market as measured by the S&P 500, because we can measure how volatile it has been over historical time periods.

Implied volatility, on the other hand, is the measure of volatility that's derived from the actual market price of an option, or a stock, or the market.

To calculate implied volatility, you would have to throw out the theoretical price of what something (like an options contract) should be, since that is calculated by using the Black-Scholes options pricing model, which incorporates historical volatility.

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To figure out what something's implied volatility is, you'd plug in all the numbers that comprise the Black-Scholes model (except the historical volatility number), substituting the actual market price for the theoretical price (which is what the model solves for), and instead solve for a new volatility number.

Implied volatility is the expected volatility buyers and sellers of that option are pricing it at, in the real world.

In other words, implied volatility is what the market expects volatility to be.

Origins of the VIX

The Black-Scholes options pricing model (the one that uses historical volatility as part of its equation to calculate theoretical options prices) was plugged into the computers we used at the CBOE back in the early 1980s when I was a market-maker on the floor.

If you wanted to buy or sell an option, you might look at what the theoretical price should be, to see if you could buy it cheaper than what it was supposedly worth or sell it for more than what it was theoretically worth.

However, what was obvious to a bunch of us was that theoretical prices derived by formula were quite different from the prices at which we were buying and selling.

Necessity is the mother of invention, and we were trying to make money. So, to figure out why there was such a difference between theoretical prices and actual prices, a handful of us started playing with the Black-Scholes model.

Shah Gilani

About the Author

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Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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