Forecasting Volatility in Options Trading - Nexus between Historical Volatility and Implied Volatility

Volatility is the most imperative input in the pricing of an option. As similar to underlying asset price, strike price, risk free rate of interest, remaining time to expiration and dividend, volatility also influences much on option pricing and trading. For a sophisticated trader, option trading is nothing but volatility trading and the trader who can forecast volatility the best is the most successful trader. The objective of this paper is to elucidate the efficiency of the market participants in forecasting the implied volatility using historical volatility and to study the relationship between historical volatility and implied volatility. This is done by considering ten stocks and their respective options which are consistently traded during the years 2014 and 2015. The stocks returns are tested for stationarity and then historical volatility is calculated. Using the Black Scholes option pricing model the implied volatilities are calculated. To check the nexus between historical volatility and implied volatility, Regression Analysis (OLS) and Grangers Casuality Test was conducted through Eviews. It was observed from the study that stock returns are stationary series and the historical and implied volatilities are significantly different and historical volatility does not have casual effect on forecasting implied volatility. This proved that implied volatility cannot be forecasted only by historical volatility, there were other factors (μ) that determines the implied volatility forecasting.