Understanding volatilities is crucially important, especially in today’s markets. And if you believe that this is true only for those who trade options, you would be very wrong. In our new notes we are explaining all you need to know about volatility (or, better, volatilities) and how you can use them to make more informed trading decisions.
To understand all important aspects about volatilities and how they can help our trading, check the note we published.
It is usually difficult to monitor all implied volatilities (i.e. the entire volatility surface) so, in order to gauge the market-perceived risk in the market, we usually focus our attention to ATM volatilities. These give us an immediate view of the volatility that the market is anticipating for that specific underlying until the option maturity date.
One point to pay attention to when monitoring ATM volatilities is the following. When the market moves, so does the ATM point. If, for example, on date 1 the market was trading at 453 and on date 2 it falls to 423, the ATM point has changed from 452 to 423 as well.
If we compare the smiles on the two dates, we can see that on date 2 we have an increase in implied volatilities but if we only look at the ATM volatility we are tempted to conclude that volatilities have moved from 19.5% to 29%. Instead, on a fixed strike basis, we can see that the 423 strike has moved from 26.4% to 29% while the 452 just from 19.5% to 20%.
The presence of the skew makes the ATM volatility move along the smile, so especially during a large movement it is important to understand that the movement we observed in the implied volatilities is driven both by a change on a fixed strike basis and the fact that the ATM points shifts upward when there is a negative skew.
The bottom line is that it is important to critically look at the changes in the ATM volatilities to understand what is really happening to implied volatilities.
This and much more is available in the note we have published on this topic.