Application of Volatility Forecasting Models in Options Trading

<p style="text-align: justify;">The value of volatility is very important to equity and derivatives traders. Traders are interested in which direction the market is moving and what is the future of the market but they are also interested in the pace of such movements. Moreover volatility is a key and, perhaps, the most important factor when calculating the price of financial options. There is great amount of studies in this field: Vasilellis and Meade (1996), Dunis and Gavridis (1997) and Connolly (2000).</p><p style="text-align: justify;">The primary aim of the proposed study is to create successful trading strategies based on the differences between the market&rsquo;s estimate of future volatility and the estimates produced by various forecasting models: if the forecasted volatility was higher than the implied volatility, it would imply that the option was underpriced in the market and the call option should be bought.</p><p style="text-align: justify;">Comparing the volatility forecasts with the implied volatility of the corresponding at-the-money index option contract allows to understand whether successful volatility trading models can be developed.</p><p style="text-align: justify;">There are two basic models that have been used to achieve the volatility forecasts:</p><p style="text-align: justify;">GARCH - generalized autoregressive conditional heteroskedasticity. Forecasts of volatility provided by this model based on previous values of volatility and previous periods&#39; error terms. &nbsp;&nbsp;</p><p style="text-align: justify;">COMB - it is modification of GARCH model, which includes additional market based information - implied volatility.</p><p style="text-align: justify;">The following values of implied volatility have been used to test analyzed trading strategies:</p><p style="text-align: justify;">1) Implied volatility calculated by using Black Scholes Model (IV)</p><p style="text-align: justify;">2) Implied volatility provided by Moscow Exchange (RTSVX)</p><p style="text-align: justify;">In this paper four trading strategies were developed by combinig various methods of forecasting and different types of implied volatility:</p><p style="text-align: justify;">1) IV &ndash; GARCH (1, 1)&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p><p style="text-align: justify;">2) IV &ndash; COMB&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p><p style="text-align: justify;">3) RTSVX &ndash; GARCH (1, 1)&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;</p><p style="text-align: justify;">4) RTSVX &ndash; COMB</p><p style="text-align: justify;">All the strategies were analyzed and the performance assessed in terms of the profit (loss) generated.</p><p style="text-align: justify;">In order to achieve this goal the special financial data were collected: daily closing prices for the RTS index future; prices for option on this index. Data were extracted from &ldquo;The Bloomberg market quotes&rdquo;, &ldquo;Yahoo Finance&rdquo;, &ldquo;Finam&rdquo;, &ldquo;MOEX&rdquo; and cover the period from 01.07.09 to 30.12.2013 (1123 observations).</p><p style="text-align: justify;">The result obtained was expected: the most profitable and stable strategy is IV-COMB strategy based on COMB predictions. It allows to produce great profit per trade (6463,73) during the entire investigated time period, probability of a profitable trade is about 66%.</p>