Implied volatility is important market parameter because it represents a consensus on market volatility. It’s a form of price discovery. Option models are tools that allow us to measure the changes in consensus but, as we have seen, they also pick up artifacts of the model’s time assumption.
One of my hobby horses is the misconception that trading is about prediction when measurement is the job to be done. If our choice of measuring device influences the reading, it’s a bit like using your thumb to measure your heart rate — it has its own pulse possibly confounding the count.
We should refine a calendar to not be so naive that it:
- Acts as though a business day, an earnings day, an FOMC meeting day, the day after Thanksgiving, and the Fourth of July all contain the same proportion of a year’s volatility
- Treats weekends as if no news is possible
Just like we use accrual accounting instead of lumpier cash accounting, we want to use an option calendar to give a more accurate view as to how variance time passes. This disentangles the changes in consensus from the artifacts of the option model’s naive day count. The closer we get to reality the smoother the vol changes will be but more importantly, the better they isolate changes in consensus.
Before venturing further it’s worth mentioning that for anyone who isn’t interested in “trading vol” this is all overkill. If the extent of your interest in implied vol is “what volatility do I use to weight my risk-parity portfolio?”, then the dirty IVs you get from your brokerage software are totally fine.
But if you are in the business of trading options because their volatility parameter looks mispriced — this is table stakes. That is a low-margin business. (If you think it’s not, you’re missing something — and if you still disagree you better be rich as hell from trading lots of options to argue otherwise).
Volatility trading across assets with their various expiration schedules and dynamics (Vail Resorts’ stock price is less sensitive to macro than gold — this means variance time passes differently overnight for each of these assets. One market is 24/7 and has trading centers in London, New York, and Asia) makes apple-to-apple comparisons of implied volatility impossible if you use the wrong rulers.
Next section: Learn a simple way to construct your own ruler: A Variance Schedule