2
$\begingroup$

I know that each individual option has it's own implied volatility, but how do you go about calculating the overall implied volatility for an underlying?

For example when someone sais the IV of a certain underlying is 40%, they are not referring to a specific option/strike. They mean that the option market as a whole is implying a volatility of 40%. How is that 40% calculated? Im guessing it is something along the lines of calculating the IV for every option available and taking some sort of average?

Secondly, how do you go about calculating the historical IV over a given time period. For example in most options trading platforms (eg: TWS, ThinkOrSwim, etc) you can pull up a chart of a specific underlying along with it's IV over a given time period. How would you go about recreating that?

Again I presume you do something like:

  • One day at a time, get the closing price for every active option
  • Calculate the IV for all the options at every strike
  • Perform some sort of average
  • Move to the next day

It seems impractical to calculate the IV of every single active option. Is it perhaps only done using the front month? (and if so, does that include weeklies and monthlies?)

enter image description here

Improve this question
$\endgroup$
3
  • 3
    $\begingroup$ I believe you may be referring to the "New VIX calculation method" aka the "variance swap method" which indeed does take all options at a certain maturity into account, though it is not simply an averaging of Black Scholes IV's, but something original. There is a lot written on that, including on quant.stackexchange. An overview: math.nyu.edu/research/carrp/papers/pdf/JODCarrWu.pdf $\endgroup$
    – nbbo2
    Nov 6, 2015 at 14:10
  • 1
    $\begingroup$ this is also called "model free implied volatility" method $\endgroup$
    – nbbo2
    Nov 6, 2015 at 16:28
  • 1
    $\begingroup$ It may be called "model-free", but it isn't. It relies on the hypothesis that the underlying's price follows an Itô process under the risk-neutral measure; or, in other words, it postulates an absence of jumps in the price process. Bit problematic in 2008-09. $\endgroup$
    – ocstl
    Feb 24, 2016 at 23:48

3 Answers 3

Reset to default
2
$\begingroup$

One way to do this would be to try to replicate the VIX calculation, which is calculated as the square root of a 30 day variance swap level. A variance swap can be replicated (in theory) using standard European calls and puts (you would need to convert American style stock option prices to European style prices using option models). The weighting scheme is inversely proportional to the square of the strike price, and in theory uses all option prices from zero to infinite strike. Of course we don't have this many option prices, and the actual liquid set of option prices is much smaller than the set that gets closing prices on the exchange, so one needs to make pragmatic choices. There are many papers on how to practically replicate variance swaps. Here is one good paper by JPM:

JPM Var Swap Paper

Improve this answer
$\endgroup$
1
  • $\begingroup$ fitting a vol surface can help to make variance swap prices. If one is meticulous about making an arb free surface (including calendar arbs), the wings can be well controlled even when strikes are somewhat sparse. Then choose the expiry that is preferred and do the usual var swap pricing with the appropriate slice (smile) of the vol surface. $\endgroup$
    – FinanceGuyThatCantCode
    Mar 29, 2017 at 13:13
1
$\begingroup$

Most software vendors use ATM implied volatility (usually interpolated to 30 days) which is how the old VIX index was calculated. AFAIK no vendor provides new VIX/MFIV as default - it is simply not as robust.

Improve this answer
$\endgroup$
1
$\begingroup$

For historical volatility I actually like this article: http://www.todaysgroep.nl/media/236846/measuring_historic_volatility.pdf

it provides several of the better known methods for calculating historical vol, which of course could be done manually. Just being aware of the upsides and downsides of each method.

As for implied vol, yes as onlyvix has said it's generally ATM that they use. You could just take the closest atm straddle for each day and calculate it via some sort of root finding method such as the Newton Method. Then keep track of each day vs where the underlying was.

There are also several online resources that have this done for you as well.

Improve this answer
$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.