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Thursday, June 10, 2010

Estimating Future Volatility Direction with TEMA Indicators

- All options traders want to know future volatility. All options pricing models try to estimate future volatility. Firms invest millions in the latest high-tech supercomputers and pay a battalion of PhDs that use GARCH, multivariate regression, neural network models, etc. to estimate future volatility. Why? Because if you knew or can accurately estimate what future volatility would be, then you could determine if current implied volatility of options (hence current options prices) is too low or too high. You could buy/sell undervalued/overvalued options and make billions of dollars.
- Well, I am highly analytical, but I am no scientist. And I cannot predict what future volatility would be. But I do have options trading experience, some expertise in technical analysis, and a good sense of what direction future volatility is likely to be.
- Most options traders dismiss technical analysis as alchemy. I do not blame them because most of technical analysis (i.e. chart pattern reading, fibonacci, etc.) you hear often about is worthless. Heck, many so called technical analysis experts do not even know how to draw trendlines properly. But there are simple but very powerful tools in technical analysis that you could use as a guide, rules of thumb. You live your life that way, why would you not incorporate guides to your trading and investing?
- Jeffery Owen Katz, Ph.D. writes in his oft read book ("Advanced Option Pricing Models...", McGraw Hill); "Future volatility is also affected by the location of a stock's price relative to its moving average, by the slope of the moving average,...by where the current price lies with respect to recent highs and lows,..." Well that reads to me that technical analysis could be very useful to estimating future volatility!
- The graph above shows the weighted average of implied volatility for SPY (taken from LiveVolPro) since the beginning of 2010. I also graphed the estimated future volatility calculated by using my indicators shown on TEMA charts. My estimated future volatility is determined by a function of Volatility 2 Indicator,Volatility 1 Indicator, and the Linear Regression Indicator. What I see is that my future volatility estimates often turn higher/lower before it is reflected in the trend of implied volatility!
- I need to do more analysis on other stocks and for longer time periods to make a more definitive conclusion. But I am sharing this with you now because I feel strongly that TEMA charts and indicators are fundamentally sound when used as a guide. At least, I hope to educate and bring about greater awareness to equity/options traders....

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