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Thursday, December 20th 2018

Term Structure of Implied Volatility

Term Structure of Implied Volatility

Summary

ORATS summarizes the term structure parameters using the implied volatility at-the-money for each expiration, which can be viewed historically as technical indicators against stock price and implied volatility. The term structure is important to estimate the earnings effect for stocks with earnings announcements upcoming and the parameters of the term structure can be described as the implied volatility at the constant 30-day maturity, IV at the 2-year maturity, earnings move, and slope of the term structure for the first 45 days.

ORATS summarizes the term structure parameters using the implied volatility at-the-money for each expiration. The summarized IV term skew can then be compared to the actual expiration IVs to observe any outlier months and the shape of the term structure can be observed for clues about the up-coming expected movement in the stock.

The term structure parameters can be viewed historically to test as technical indicators against stock price and implied volatility.

The term structure is also important to estimate the earnings effect for stocks with earnings announcements upcoming and how IV might fall after earnings.

The parameters of the term structure can be described as follows: 1) implied volatility at the constant 30-day maturity 2) IV at the 2-year maturity 3) earnings move 4) slope of the term structure for the first 45 days.

Consider CSCO as an example of summarizing the term structure parameters. The goal of the summarization is to have parameters that are comparable over time and to other tickers. To accomplish this, for stocks with earnings the term structure will be summarized by taking out the implied earnings effect.

In CSCO's example above, the 30-day ex-earnings implied volatility is 18.6% and the 2-year IV is 17.2%. The implied earnings move in percentage terms is 5.1% and the slope of the first 45 days of term structure is 0.12%. The earnings effect for each expiration is circled above.

The implied volatility at the constant 30-day maturity reading can be thought of as "the VIX of each stock". In ways this calculation is richer than the VIX that uses options prices of the two expirations around the 30 day. The VIX is rarely close to the true at-the-money implied volatility. ORATS uses many options implied volatility to arrive at a very accurate ATM IV and interpolates with expirations around the 30-day.

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