Monday, August 10, 2009

Understanding the Volatility Cone

One of the tools I learned to appreciate and use while studying Dan Sheridan's course is the volatility cone. A few traders use this tool, and I think that Dan Harvey was the first mentor to talk about it in one of his sessions. I got hooked.

Let me put it in simple terms: The volatility cone displays what you are "accepting" as the reality when you sell options. It simply means that, given the current volatility levels, the underlying will be in a certain range for a certain number of days.

The cone is nothing more than plotting those price levels day-by-day for the duration of the trade. The way I use the cone is to understand where the underlying is in relationship to where it was (and where market makers were expecting it to be in the future) when I first started the trade. If we start moving beyond the 1 or 1.5 st. deviation curve, it is going outside of the parameters I assumed to be "true" when I sold those contracts, and therefore, my initial assumption is no longer valid and likely to be challenged.

Let's say you sell an Iron Condor, using the original cone as your determination, you sold the CALLs and PUTs from within 1 st. deviation till expiration. If after you sell those contracts, the underlying starts to move beyond the cone, there is a greater chance that it can move beyond your short strikes by expiration. Therefore, your condor will be in a tough spot and likely to be losing money or needing some sort of adjusting.

How to calculate: I start by gathering the "implied volatility" number from TOS for the stock/etf/index the day I enter the trade, then I calculate 1 or 1.5 standar deviation for 1 day, 2 days, 3 days, 4 days, etc.. Once you have this calculated you can then plot those values in a chart and they should look like the cones you see in the blog.


Hope this helps.
Gustavo

5 comments:

B-rad said...

Gustavo,

Thanks a lot! I have been trying to construct some of your excel sheets myself but I'm no excel wizard. Thanks for finally posting this!

Anonymous said...

Hi Gustavo,

what data is the orange lines you have plotted on the volatility cone spreadsheet? Is this your breakevens or short strikes?

Anonymous said...

Hi Gustavo,
Thank You for amazing blog.
I have been trying to construct your excel sheet like here:

http://1.bp.blogspot.com/_rZAxPuYihEM/SoBqq3J3VwI/AAAAAAAADEQ/cHVxPPv11nY/s1600-h/VolCone.png

But I have another results in column "1 st dev".
Please, what is the formula for calculate column "1 st dev" ?

Thank you.

Tatalan.

Gustavo's Trades said...

Here it is, directly from my sheet:
=($C93*$D$93*(SQRT(A93/253)))

A93 is the number of days

C93 is the current price

D93 is the volatility (in percent)

Note that what you may be doing differently is the number of days. I use number of trading sessions instead of calendar days in one year. The formula is pretty much standards.

Cheers!
Gustavo

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