Understanding and properly calculating accurate volatility levels
for
options on futures is imperative for spread traders. In
order to get accurate volatility levels, you must first determine
a base volatility for the two options on futures involved in
the spread.
Getting a base volatility for the options on futures must be
done because different volatilities in different months cannot,
and do not, get weighted evenly mathematically.
Since they are weighted differently, you cannot simply take
the average of the two months and call that the volatility of
the spread; it is more complicated than that for options on
futures.
The problem is related to calculating the spreads volatility
with two options on futures in different months. Those different
months are usually trading at different implied volatility assumptions.
You cannot compare apples with oranges nor can you compare two
options on futures with different volatility assumptions.
It is important to know how to calculate the actual and accurate
volatility of the spread because the current volatility level
of the spread is one of the best ways to determine whether the
spread is expensive or cheap in relation to the average volatility
of the options on futures.
There are several ways to calculate the average volatility of
options on futures. There are also ways to determine the average
difference between the volatility levels for each given expiration
month. Volatility cones and volatility tilts are very useful
tools that aid in determining the mean, mode and standard deviations
of options on futures implied volatility levels and the relationship
between them.
The present volatility level of the spread can then be compared
to those average values and a determination can then be made
as to the worthiness of the spread. If you now determine that
the spread is trading at a high volatility, you can sell it.
If it is trading at a low volatility, you can buy it. But first
you must know the current trading volatility of the spread.
In order to accurately calculate volatility levels for pricing
and evaluating a time spread, the key is to get both months
on an equal footing. You need to have a base volatility that
you can apply to both months. For instance, say you are looking
at the June / August 70 call spread.
Junes implied volatility is presently at 40 while Augusts
implied volatility is at 36. You cannot calculate the spreads
volatility using these two months as they are. You must either
bring Junes implied volatility down to 36 or bring Augusts
implied volatility up to 40. You may wonder how you can do this.
Actually, you have the tools right in front of you. Use the
June vega to decrease the June
options on futures value to represent
36 volatility or use Augusts vega to increase the August options
on futures value to represent 40 volatility. Both ways work
so it doesnt matter which way you choose.
Lets use some real numbers so that we may work through an example
together. Lets say the June 70 calls are trading for $2.00
and have a .05 vega at 40 volatility. The August 70 calls are
trading for $3.00 and have a .08 vega at 36 volatility. Thus
the Aug/June 70 call spread will be worth $1.00.