A Brief Look at Volatility and

Using Volatility for Value

Peter ONeill is currently Chief Risk
Officer and Head of Finance for Uniper
Global Commodities North America. He
has been involved in energy markets
and risk management for almost 20
years, having worked and held roles in
various multinational energy firms.
Abstract: Despite the fact that many studies have proven
a strong correlation between volatility and market risk, to
the beginner the statistical nature of volatility is often not
well understood. The fact that rising volatility suggests a
declining market with an increase in risk and a decrease in
return and that practitioners use different volatility models
to exemplify different aspects of market risk are concepts
that can be unfamiliar or foreign to the novice student.
This brief describes the normal distribution assumptions
of trend volatility (historical price volatility) and its differ-
ence from implied volatility, which is derived from the
current option price and illustrates current market risk.
Both volatility methods are described in detail including
calculation in Excel. Basic option theory is covered. There
is also an examination of building/using a rolling front
month future contract, finding price, volatility, and option
information using Bloomberg. These authors simplify the
query regarding the richness or cheapness of volatility.

Keywords: At-the-money (ATM), backwardation, B lack-Scholes

Leslie McNew is currently Managing
Director of N3Q, MMspire Trading
Company and Executive in Residence
of the Kania School of Management,
University of Scranton. She has
30 years of experience in physical
and financial markets, and has held
senior risk management roles in five
Fortune 500 companies.
option pricing model, Bloomberg, call, commodity, contango,
derivative, Excel, front contract, future, GOAL SEEK, histori-
cal volatility, implied volatility, in-the-money (ITM), mar-
ket expectations, mean reverting, natural gas, natural log,
normal curve, option, option premium, out-of-the-money
(OTM), peak heating months, price, put, rich/cheap, risk,
rolling front contract, shoulder months, standard deviation,
standard normal distribution, statistical volatility, strike
price, time until (option) expiration, underlying price, value
at risk, volatility, volatility skew, volatility surface
Many students enter the finance workplace without a firm
introduction to the concept of volatility and probability of

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 A Brief Look at Volatility and Using Volatility for Value

performance payout. This article begins by
discussing basic market volatility and payout
performance based on basic assumptions
using basic equations and graphs. It then
moves to a discussion of the differences be-
tween implied volatility and historical volatil-
ity. Since historical volatility is used as trend
volatility, the article shows how to build a
historical volatility model in Excel. Finally,
the article ends with how to use Bloomberg
in regard to volatility and volatility calcula-
tions. The article does assume some basic
knowledge of Bloomberg and options.
Volatility and Risk
In its simplest form, volatility is risk. Vol-
atility is often portrayed as an annualized
number, meaning that if volatility were
9%, we would expect the price of the un-
derlying to move 9% over the next year, up
or down. If the price of the underlying was
$115.00 and volatility was 9%, we would
expect the underlying price of the instru-
ment to move in the range of $125.25 to
$104.65 over the next year. See Figure 1.
If volatility is low, then we expect a nar-
rower distribution in regard to the price
changes of the underlying asset. A low
volatility allows for a narrower range of
prediction of the underlyings future per-
formance. A high volatility implies that the
underlying will have more variable prices
in the future and that there will be a far
wider range of outcomes when it comes to
predicting future prices.
Volatility is not static; it changes through-
out time. Generally, there are two basic
types of volatility used in managing risk
on a trading floor: historical and implied.
Historical volatility helps illuminate the
volatility trend and is backward looking.
Historical volatility is realized volatility.
Realized volatility (statistical volatility) is
based on the underlyings closing prices
(for a period, such as a day, a week, etc.).
Given that historical volatility is often mean
reverting, it follows that historical volatility
is trend volatility (Marshall, 2008).
Implied volatility illustrates what the
market expects the volatility to be in the fu-
ture and is forward looking: it is a measure
of market expectations of volatility of the un-
derlying. Implied volatility can be inferred
from the option price based on the under-
lying. For example, at-the-money (ATM)
volatility is inferred from the closest option
price based on the current underlying price.
Figure 2 attempts to illustrate the differ-
ences in implied volatility methodologies.

Figure 1: Using volatility to predict price changes over a one year period

Figure 2: Differences in basic volatility methodologies

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 A Brief Look at Volatility and Using Volatility for Value

Historical Price Volatility Figure 3: A review of the normal

The most common methodology for calcu-
lating historical volatility is to determine
the standard deviation of returns or loga-
rithmic returns on the basis of daily closing
prices. Historical volatility is sometimes
called statistical volatility and is calculated
by finding the standard deviations of an
underlyings returns over a fixed number
of days. The user of the data defines the
snapshot of the historical volatility period
(the fixed number of days).
Historical volatility can be calculated as
a one-day, one-standard-deviation move in
price, annualized. Thus, when we say that
the annualized, historical volatility of an
underlying is 9%, we are expecting only a
9% move in prices, over the next year. This
translates into risk as restating the previous
sentence: we are about 70% sure that we
will see prices move only about 9% over
the next year. For prices to move beyond
the +/ 9% range, there is only about a 30%
likelihood of that happening. For example,
if the underlying price of our instrument
were $100, and its historical volatility was
9%, we would expect, with 70% likelihood,
that our price range would be $91$109. We
have only a 30% likelihood of prices being
lower than $91 or higher than $109.
Figure 3 is a review of the normal distri-
bution: here is the link between volatility
and probability (meaning risk).
distribution
https://www.spcforexcel.com/knowledge/
basic-statistics/explaining-standard-deviation
Aside: Creating a Continuous (Rolling)
Front Contract Natural Gas Future
To create a quick and easy view of histori-
cal volatility, we need to create a series of
continuous (rolling) security prices, in this
case, the front month natural gas future.
As we can see from the Bloomberg Screen
Shot 1, there are many natural gas futures
contracts. Each contract has a set defined
expiration schedule around the end of the
month before the respective contract month.
The term front contract is used to denote
the contract closest to expiration date, NOT
in expiration month. For example, if we
were in February, the front contract would
be in March. If we were in March, the front
contract would be in April (as we would be
in the delivery/expiration month). As of
4/11/2017, the front contract is May.

Bloomberg Screen Shot 1: List of Current Natural Gas Futures as of 4/11/2017

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