A Simple Measure of Risk.

By

Craig Garbie

As an investor or trader we are always concerned with levels of risk. One simple way to quantify risk is to look at implied volatility of the listed at the money options of your particular trading vehicle.The implied volatility of at the money puts and calls is the markets best guess of risk in the marketplace.

In general, option pricing models assume a Gaussian, or random distribution. This is the bell curve familiar to novice statistics students. The implied volatility measure is the one standard deviation area of the bell curve applied to the next 365 days. Remember, assuming a random distribution, the first standard deviation will represent about 68% of the sample the second standard deviation about 95% and the third 99% of the sample. Okay, so whats the point, right?

Lets see an example. I will use the stock market data from Dec. 13^th . Our proxy for the stock market will be the S&P 500 and I will use the CBOE VIX for our estimate of implied volatility. On our date the cash S&P 500 closed at 1488.41. and the VIX settled at 22.56. What thie data tells us is that all being equal the stock market has a 68% chance of closing between 1824.21 and 1152.61 on Dec. 13^th, 2008. We arrive at these figures by taking the VIX , which is essentially a percetage, and multiply by the markets close on Dec.13^th . We then both add and subtract that figure from the close of the day to arrive at our our calculation. That is (.2256 * 1488.41)= 335.80 and 1488.41+ 335.8= 1824.21 also 14488.41_335.8= 1152.61. If we want to increase our confidence level we can go out to two or three standard deviations. For a 99% confidence level we need to go out to three standard deviations and our range dramatically widens to 2495.81 to 481.01. Those levels may seem uncomfortable, but that is where the data points.

Bear in mind , this is not perfect.Implied volatility changes on a constant basis and it is “implied”, that is code for a good guess. Still, it provides us with a valuble way to measure probable risk and make more informed, rational decisions.With thousands of market participants directly and indirectly contriduting to the factors making up the implied volatility calculations it is a remarkable and simple to use resource. Some levels of implied volatility can actually signal unusual complacency and provide red flags especially in the stock market.Do a little research to see if you can uncover any tendencies in your investment vehicle.

Any instrument with liquid listed options will be a candidate to use this technique for estimating risk. We can also refine our time periods down to a single day volatility if we wish. Maybe in a future article I can go through that process in detail. Until then keep your eyes on that implied volatility.