Measuring Implied Volatility: Is an Average Better?

30 Pages Posted: 31 Oct 2000

See all articles by Louis H. Ederington

Louis H. Ederington

University of Oklahoma - Division of Finance

Wei Guan

University of South Florida St. Petersburg

Date Written: August 2000

Abstract

Based on the law of large numbers, several options researchers have proposed using (different) weighted averages of the implied standard deviations, ISD, calculated from numerous options with the same expiry to obtain a single best ISD measure. However, most commercial providers use an average (and often an equally weighted average) of just a few at-the-money ISDs. We find that the practitioners' restricted averages forecast slightly better than the broader weighted averages from the academic literature but that neither group forecasts actual volatility very well.

We suggest an adjustment to the extant models which improves their forecasting ability considerably. We also suggest a new weighting scheme which yields better estimates on an out-of-sample basis than any of the existing models (adjusted or unadjusted). However, we also find that because there is little independent noise in individual options ISDs (at least in the S&P 500 options market), there is little gain to averaging. Consequently, individual option ISDs and averages of just a few ISDs forecast almost as well as weighted averages of many ISDs and the weighting scheme choice is relatively unimportant.

Suggested Citation

Ederington, Louis H. and Guan, Wei, Measuring Implied Volatility: Is an Average Better? (August 2000). Available at SSRN: https://ssrn.com/abstract=240325 or http://dx.doi.org/10.2139/ssrn.240325

Louis H. Ederington (Contact Author)

University of Oklahoma - Division of Finance ( email )

Norman, OK 73019
United States
405-325-5591 (Phone)
405-325-7688 (Fax)

Wei Guan

University of South Florida St. Petersburg ( email )

College of Business
140 Seventh Avenue South
St. Petersburg, FL 33701-5016
United States
(727) 873-4945 (Phone)
(727) 873-4192 (Fax)

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