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Wednesday, March 13th 2019

Forward Volatility: The Future Is Now

Forward volatilities foretell important things about the future of implied volatility and historical volatility.

Summary

Forward volatility is a measure of future implied volatility. Calculating the forward or future volatility over a period of time can expose anomalies in the term structure and provide insight into the movement of the underlying instrument. ORATS calculates forwards using neighboring constant maturity implied volatilities and also calculates flat forwards. The ratio of flat forward to forward is a good signal for foreshadowing movement in the underlying instrument. ORATS also calculates forwards based on the ex-earnings implied volatility skew.

Forward volatility is a measure of future implied volatility.

But how can you know the future?

Ask the term structure of implied volatilies!

You calculate the forward or future volatility over a period of time by extracting the IV at the beginning of the period and the end of period. ORATS calculates forwards using the neighboring constant maturity implied volatilities 20, 30, 60, 90 and 180 days and also for the 30 to 90 day period.

Calendar pricing can be normalized by using a this forward volatility calculation. The forwards can then expose anomalies in the term structure, which month is too high and which too low.

For example, assume the implied volatility 20 days to expiration was 9.1% and the 30 day IV was 9.6%. Logically, if the volatility was 9.1% for 20 days, in order for the 30 days to be worth 9.6%, for the 10 days after the 20 days and before the 30 days the stock would have to move more than 9.6% in order to move the average up to that number. Make sense? The calculation for the standard forward volatility finds this ten-day forward volatility to be 10.5%.

There is another way to calculate forward volatilities; we call Flat Forwards, that is a bit more involved but yields a measurement of 11.7% for the same period as above.

Interestingly, in low volatility periods, we have found the flat forward to be higher than the regular forward. In high volatility periods the flat is lower than the regular forward.

We have found that the ratio of the flat forward to the forward is a good signal for foreshadowing movement in the underlying instrument. We found the lower this measurement, the worse things will be for the market going forward, i.e. < 1 is bad. More on this signal in another post.

Another important twist at ORATS is that we also calculate forwards based on the ex-earnings implied volatility skew. In ex-earnings IV ORATS removes the implied volatility attributable to earnings announcement. Since ETFs do not have earnings announcements their forwards do not have ex-earnings effects.

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