Weather Forecast

We all love to complain that “The weather forecast was wrong, again!” Yet, we keep looking at the forecast on a daily, sometimes hourly, basis. Why?

Because even if they are not 100% accurate, these forecasts convey valuable information that often outweighs the occasional miss.

What if you could get a “weather forecast” for individual stocks, or the overall market? Is there such a thing?

ANSWER: Surprisingly, yes, in a compact form known as a Volatility Surface.

Expected Volatility

Options are traded on more than 4,000 listed stocks, on broad market indices, and on ETFs covering specific industries.

The price of these options incorporates a forecast of the expected volatility of a specific stock, index, or sub-index over the term of the option.

By extracting the forecast embedded in all the options of a specific stock we can draw a surface showing the expected volatility.

Example: SPDR S&P 500 ETF Trust (SPY)

Here is an example of such a surface for SPY, drawn from the option prices on SPY:

The shape of this surface is one often encountered and reflects a forecast that could be translated as “seasonal weather expected”, i.e., nothing out of the ordinary.

It shows higher expected volatility in the short term, then declining to a consistent level.

But “seasonal weather” is not the same for Miami and Minneapolis, and it should not surprise you that it will not be the same for a large cap established company and a young company exploring the latest development in its field.

For example, as of this writing, the expected volatility for Johnson & Johnson (JNJ), a well-established consumer goods stock, clusters around 19%.

For Microsoft (MSFT), a well-established tech stock, it’s around 25%.

And for Nvidia (NVDA), a “flavor of the year” stock, it’s in the low 50s.

So, what is this forecast forecasting?

In one word: volatility.

Implied volatility (IV) is the market’s best estimate of how volatile a stock or an index will be over the term of the option.

A few points to remember.

First, volatility is non-directional.

This forecast says nothing about whether the underlying security is expected to go up or down.

As far as the forecasters are concerned, there is no difference between 4% up or 4% down.

Second, the forecast is expressed as an annualized number.

So, when IV is quoted as 41%, it is understood to mean 41% annualized (this is akin to how interest rates, even short-term ones, are quoted).

What Type of Radar Is Used to Create a Forecast?

We look at the bid and ask prices of every relevant option.

Note: options expiring in less than a week and options with a zero bid are not deemed to impart valuable information and are therefore not included.

These individual options all contain an implied volatility forecast, and all these forecasts are woven together into the volatility surface.

What if you trading horizon is shorter than 1 year? No problem, this forecast can be adjusted for different time frames.

For example the annualized forecast can be turned into a daily forecast by dividing it (the annual) by 16, into a weekly forecast by dividing by 7.2 and a monthly one by 3.5.

Annualized Forecast

Still, what does it mean if the annualized forecast is 32%?

The interpretation is that there is a 2/3 probability that one year from now a $100 stock will somewhere between $76 and $132.

(See the technical note below that explains why the range is not $68 to $132.)

There is therefore a 1/3 probability that the stock will be either above or below this expected range, with an equal chance of it being above or below this range.

What if our time horizon is much shorter, say 1 day?

A 32% volatility translates into a 2% daily volatility so for our $100 stock, its expected range is $98 to $102.

Once again, there is a 1/3 probability that the stock will move outside of this range.

Are all volatility surfaces similar to the SPY example above? No.

A “Disturbance in the Force”

Occasionally, some expected disturbance can be spotted.

For example, here is the volatility surface for AFRM as of 14 OCT 2024:

Notice the ridge in the month of AFRM. This should not be surprising since AFRM’s earnings are expected on 13 NOV 2024.

So the options expiring after the earnings announcement are forecasting higher volatility than the options expiring before the announcement.

This is not surprising, as earnings oftentimes move the underlying stock a significant amount.

Other events that may cause IV to increase include anticipated announcements from a regulatory agency (FDA, FAA, etc.), the expected resolution of a legal matter, takeovers (announced or rumored), and other expected events.

The surface itself will not tell you the nature of this event, but it does raise a red flag and is a clear signal that doing one’s homework (i.e., researching the reason for this irregularity) needs to be done.

The Wrong Forecast?

Like the weather forecast, volatility surfaces will at times be “wrong”.

What about that storm of the century that never appeared?

Or that afternoon downpour no one saw coming?

New information arrives to markets constantly, which will change prices (and, in turn, volatility expectations).

Still, volatility surfaces present valuable information and should be a part of your investing/trading tools.

Technical note

Why, as noted above, is the expected range of a $100 stock with a 32% IV from $76 to $132, and not from $68 to $132?

If a stock rises from $76 to $100, it has increased 32%.

From $100 to $132 is another 32% increase.

$100 is therefore “half-way” between $76 and $132.