Predicting Volatility

Predicting volatility is a really one-time topic. Every finance educatee has been taught to role the GARCH model for that. But similar nearly things nosotros learned inward school, nosotros don't necessarily hold off them to last useful inward practice, or to function good out-of-sample. (When was the final fourth dimension you lot necessitate to role calculus inward your job?) But out of curiosity, I did a quick investigation of its ability on predicting the volatility of SPY daily close-to-close returns. I estimated the parameters of a GARCH model on preparation information from Dec 21, 2005 to Dec 5, 2011 using Matlab's Econometric toolbox, in addition to tested how oft the sign of the predicted 1-day modify inward volatility concord alongside reality on the exam fix from Dec 6, 2011 to Nov 25, 2015. (One-day modify inward realized volatility is defined every bit the modify inward the absolute value of the 1-day return.) Influenza A virus subtype H5N1 pleasant surprise: the understanding is 58% of the days.

If this were the accuracy for predicting the sign of the SPY supply itself, nosotros should cook to retire inward luxury. Volatility is easier to predict than signed returns, as every finance educatee has also been taught. But what expert is a expert volatility prediction? Would that last useful to options traders, who tin merchandise implied volatilities instead of directional returns? The answer is yes, realized volatility prediction is useful for implied volatility prediction, but non inward the agency you lot would expect.

If GARCH tells us that the realized volatility volition increment tomorrow, nearly of us would instinctively travel out in addition to purchase ourselves about options (i.e. implied volatility). In the representative of SPY, nosotros would in all probability acquire purchase about VXX. But that would last a terrible mistake. Remember that the volatility nosotros predicted is an unsigned return: a prediction of increased volatility may hateful a really bullish twenty-four hours tomorrow. Influenza A virus subtype H5N1 high positive supply inward SPY is unremarkably accompanied past times a steep drib inward VXX. In other words, an increment inward realized volatility is unremarkably accompanied past times a decrease inward implied volatility inward this case. But what is genuinely foreign is that this anti-correlation betwixt modify inward realized volatility in addition to modify inward implied volatility also holds when the supply is negative (57% of the days alongside negative returns). Influenza A virus subtype H5N1 very negative supply inward SPY is indeed unremarkably accompanied past times an increment inward implied volatility or VXX, inducing positive correlation. But on average, an increment inward realized volatility due to negative returns is however accompanied past times a decrease inward implied volatility.

The resultant of all these is that if you lot predict the volatility of SPY volition increment tomorrow, you lot should brusk VXX instead.

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My Upcoming Workshop

January 27-28: Algorithmic Options Strategies

This is a novel online course that is dissimilar from nearly other options workshops offered elsewhere. It volition encompass how i tin backtest intraday pick strategies in addition to portfolio pick strategies.

March 7-11: Statistical Arbitrage, Quantitative Momentum, in addition to Artificial Intelligence for Traders.

These courses are highly intensive preparation sessions held inward London for a amount week. I typically necessitate to walk for an lx minutes along the Thames to rejuvenate afterwards each day's class.

The AI course of educational activity is new, in addition to to my amazement, about of the improved techniques genuinely work.

My Upcoming Talk

I volition last speaking at QuantCon 2016 on Apr 9 inward New York. The theme volition last "The Peculiarities of Volatility". I pointed out one peculiarity above, but in that place are others.

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QTS Partners, L.P. has a cyberspace supply of +1.56% inward Oct (YTD: +11.50%). Details available to Qualified Eligible Persons every bit defined in CFTC Rule 4.7.

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