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Today we will learn about the volatility Surface.

Hello youtube welcome back to my channel so today hopefully we’ll have a shorter video i think i mentioned a while ago my goal is to have a lot of five-minute videos here on youtube where they’re sort of bite-size little ideas from finance that are hopefully helpful to students or people who are interested in derivatives and unfortunately the last few videos have

Been reasonably long they’ve been for the 15 minute videos and that’s that’s just related to the fact that it’s sometimes hard to break them up into smaller pieces if all of the ideas really belong together but today’s video is hopefully going to be a nice short one and what we’re gonna learn about is term structure volatility and about the volatility surface and

What it means so the term structure of volatility is just essentially that over different maturities options will have different implied volatilities now we just did one on the volatility smile which was about different strike prices of options so this is different expiration dates so if there’s a you know a 1 month a 3 month or 6 month option available on a given

Underline we’re gonna find that each of those options has a different implied volatility know that isn’t that that doesn’t relate to a flaw in the black scholes model like our our prior example of the smile it’s actually just something that you should naturally expect and there’s lots of reasons that that options that expire at different dates would be expected to

Have different implied volatilities and the most obvious reason is just the different things can happen all for different periods so we’ll say for example if you had one option that was expiring a right before an earnings announcement date and another one that was expiring right after that date you’d expect the one that incorporated that additional information to

Cost more there’s greater volatility where for an earnings announcement day that’s usually a volatile day for a particular stock and so if you owned an option that expired after that event you’d expect to have more volatility more realized volatility occurring during the life of that option so basically when we line up all of our options so options with the same

Strike price the same underlying but different expirations will find a bunch of different implied volatilities and we can plot that and we the plot of that is referred to as the term structure or volatility and it’s a bit like if you’ve studied fixed income there’s the term structure of interest rates and so the term structure of volatility is a very similar idea

To that and it’s just the relationship between implied volatilities and time to expiration so i’ll put up on screen right now an image of a volatility surface i actually just grabbed this image from wikipedia because it’s a you know pretty decent illustration and what we’re seeing here with the volatility surface is a combination of that term structural volatility

That i just explained which is the different volatilities for different explorations and the volatility smile which i’ll link to the video i did on that it went up yesterday and the volatility smile is different volatilities for different strikes of options on the same underlying so when we combine all of those together were essentially plotting every option that’s

Available on a given underlying so all of the different strikes and explorations of options we can plot them all and we get to see that different options have different implied volatilities and we’re essentially able to use that that volatility surface to decide which options we may or may not want to trade now there’s a few useful things about the volatility this

A one thing is that you can actually almost back out that there’s there’s big news coming about a given underlying because of bumps that you might see in the volatility surface so for example if you saw really high volatility for certain dates but that might mean that there’s just a big news event but that’s likely to occur and actually you can almost just look

At the volatility surface see that the market expects you know a certain amount of volatility at a given point in time and you can then go and dig through the news on that stock and actually see what it is you know so it’s it’s kind of an interesting thing that you’re able to to do that so that is the volatility surface that’s really all we have to say on that

Topic if you tune in tomorrow we’ll we’ll start a new series which will be on real options which is applying what we’ve learned about options pricing to to trying to price other other things in finance that there aren’t actually options based upon so anyhow tune in tomorrow have a great day hit the like button do subscribe if you’d like to see more and if you’re

Interested in the book that all this is based upon it’s called trading and pricing financial derivatives and i’ve been told that it’s probably the best book on financial derivatives out there thanks mom for saying that and yeah see you guys later bye

Transcribed from video

The Term Structure of Volatility and the Volatility Surface By Patrick Boyle