Volatility Moves Sideways

Volatility Moves Sideways

In order to use the Black-Scholes Model to your advantage, you must under­stand an important characteristic of volatility. That is, volatility tends to move sideways over time. For example, Figure 7 shows an 18-year history of the Volatility Index, or VIX, which measures the volatility of the S&P 500 Index. Although the index has risen substantially over this time period, notice that the volatility did not - it just moved sideways.

This sideways characteristic of volatility is about the only constant in options trading and, consequently, is an important observation we can use to our ad­vantage. When volatility rises significantly above the long-term average, there is a tendency for it to fall and vice versa. The tendency for volatility to fall toward the long-term average is called mean reversion. That is, volatility tends to revert to the mean (average). Anytime an extreme event happens, chances are that following events will be less extreme, not more. Mean reversion is easy to understand by looking at a real-world example - one that is often explained by a jinx.