How accurate is Implied Volatility in predicting future moves?
Historical volatility of a stock is going to be based on past performance, basically its current trend.  That can be useful, but really is no indication of how it will perform in the future.  Especially with a big swing in the market. Now if you're talking about implied volatility (IV) of an options contract, that's a little different.  IV is derived from an option’s price and shows what the market “implies” about the stock’s volatility in the future. Thus it is based on the actions of active traders and market makers.  So, it gives you a bit more insight into what's going on, but at times has less to do with fundamentals. I guess a good way to think of IV based on options contracts is as an educated opinion, of the market as a whole, with regards to how much that stock could likely move over a period of time (options expiration). Also note that IV represents the potential for a stock to move, but it does not forecast direction. I don't know of any studies off the top of my head, but I'm sure there have been plenty. A change in implied volatility tells us something about what investors are thinking (or fearing) about the volatility going forward for the life of the associated option contracts (which may be short or long-lived).  IV does a good job of summarizing the information available to investors, which includes information about the past and the present. However, whether these investor views actually translate into what happens in the future is a topic of debate in the finance literature--investors do not generally know the future--there are conflicting results available.  There have been papers that show that implied volatility has predictive power in some situations, time periods, and horizons (though it is also biased) and other papers that show that it does not have statistically significant predictive power at all. The consensus last time I checked was that implied volatility is no worse than historical volatility (including methods that use trends in historical volatility to forecast where it is going) at predicting future volatility.  Whether it is significantly better and whether either reliably predicts the future is something that is not agreed on.  I take this lack of consensus as evidence that if it does predict future volatility, it does so poorly. Somewhat dated FAJ survey on the subject "How accurate is Implied Volatility in predicting future moves? How would you measure this?  If the implied volatility says that there's a 1% chance that a stock will double, and it doubles, was it ""right""?  You could also say that it says there's a 99% change that it doesn't double, so was it ""wrong""?   What you could measure is the variance of daily returns over a time period, and see how well that compares to implied volatility, but there's no way to compare IV with the absolute price movement.  If a stock goes up 0.01 each day, then the variance is 0 (the daily returns are the same each day), but over 250 the stock would go up $2.50."
"I'm far from certain, but I'll take a swing at it.  Equilibrium term structure models ""predict"" a term structure that we don't observe, and no-arbitrage models ""correct"" prediction to match reality.  An analogous place to look would be implied volatility surfaces.  Black-Scholes predicts a specific implied volatility surface (or rather, it assumes the surface is flat).  So I think a Hull-White-style no-arbitrage model might work by addressing the difference between predicted and actual surfaces.  Like term structure models, you'd take a set of observed volatilities and somehow plug them into BS so that the BS price didn't imply arbitrage opportunities within the observed set of options.  I'm not at all certain that I'm being clear, and there's a distinct possibility that I'm saying/thinking something stupid." "Using the following equations from the book a stab at the correlation can be made.   Calculating the residual volatilities from equation 2.4 The correlation of stock A with stock B is 0.378 and stock B has the higher residual volatility. However, the correlation is given as a ""simple model"", which may suggest that it is an approximation.  If I have applied it correctly, some testing shows that it is only approximate. Also of interest" I don't see a contrast. It's really hard to predict which mutual funds will do well in the future. Predicting that ones which have done well recently will continue to do well works slightly better than chance. The WSJ article and Morningstar agree on all the objective facts, they just spin them differently. No, it's not even remotely accurate in the current sense. Both markets have counterparties directly executing against one another, and both have auctions. The auction mechanics are different (with NYSE's Specialist/DMM model) but during normal market hours there isn't much difference. &gt; “If the [Black-Scholes] formula is applied to extended time periods….it can produce absurd results.”  &gt; -Warren Buffett, 2008 Letter to Berkshire Hathaway Shareholders  I will give your question more thought, and come back with a quantitative solution. It may be most fruitful to apply a backward-induction options pricing model with detailed scenario-based discounted cash flow valuation models supported by pro forma financial statement and investment analysis.    Nonetheless, my initial reaction is inline with Warren Buffett's belief that in the long-run an assumption of the Black-Scholes options pricing model is invalid (see [here](http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.613.1657&amp;rep=rep1&amp;type=pdf) and [here](http://www.elon.edu/docs/e-web/academics/business/economics/faculty/kurt/OptionValuationBuffetCritique_123113.pdf)). The perceived invalid assumption is that the distribution of expected future stock prices is *not* log-normal in the long-run. This non-log-normal view is especially true for a single company stock.   This invalid assumption results in over-valuation of options prices from Black-Scholes - which makes it much better to sell long-term options than to buy them if market participants are using Black-Scholes pricing models.  Again, without having done the math yet, my gut tells me if the option seller is using Black-Sholes pricing for long-dated options, you would be best to avoid buying them as the prices will be inflated compared to an economic reality fair price. You are missing a few variables from your calculation, particularly implied volatility.  Even so it does not look like it would be too great a predictor even if incorporated.  You should focus on calculating the option price at a different point in time (with a different underlying price) instead of using a total position value as that can be done afterwards. I programmed and use the standard Black-Scholes model to calculate expected returns.   There are many tools online to help you without doing the programming or calculations yourself. "@jlowin's answer has a very good discussion of the types of PE ratio so I will just answer a very specific question from within your question: And who makes these estimates? Is it the market commentators or the company saying ""we'd expected to make this much""? Future earnings estimates are made by professional analysts and analytical teams in the market based on a number of factors. If these analysts are within an investment company the investment company will use a frequently updated value of this estimate as the basis for their PE ratio. Some of these numbers for large or liquid firms may essentially be generated every time they want to look at the PE ratio, possibly many times a day. In my experience they take little notice of what the company says they expect to make as those are numbers that the board wants the market to see. Instead analysts use a mixture of economic data and forecasting, surveys of sentiment towards the company and its industry, and various related current events to build up an ongoing model of the company's finances. How sophisticated the model is is dependent upon how big the analytics team is and how much time resource they can devote to the company. For bigger firms with good investor relations teams and high liquidity or small, fast growing firms this can be a huge undertaking as they can see large rewards in putting the extra work in. The  At least one analytics team at a large investment bank that I worked closely with even went as far as sending analysts out onto the streets some days to ""get a feeling for"" some companies' and industries' growth potential. Each analytics team or analyst only seems to make public its estimates a few times a year in spite of their being calculated internally as an ongoing process. The reason why they do this is simple; this analysis is worth a lot to their trading teams, asset managers and paying clients than the PR of releasing the data. Although these projections are ""good at time of release""  their value diminishes as time goes on, particularly if the firm launches new initiatives etc.. This is why weighting analyst forecasts based on this time variable makes for a better average. Most private individual investors use an average or time weighted average (on time since release) of these analyst estimates as the basis for their forward PE." The options market seems to disagree...  While the implied volatility is greater than the historical volatility.. At 23% the implied isn't much higher than the past implied-vol. I'll trust the market over the stock-twits chairman.  http://www.cboe.com/framed/IVolframed.aspx?content=http%3a%2f%2fcboe.ivolatility.com%2foptions.j%3fcontract%3dC0F1D96A-D9C7-49D2-8941-45DC1B0E0B0F&amp;sectionName=SEC_TRADING_TOOLS&amp;title=CBOE%20-%20IVolatility%20Services  ... that being said -- I (like everyone and their sister) think we break 100 and move hard to 104-105. "The VIX is a mathematical aggregate of the implied volatilities of the S&P 500 Index components. It itself cannot be traded as there currently is no way to only hold a position on an implied volatility alone.  Implied volatility can only currently be derived from an option relative to its underlying.  Further, the S&P 500 index itself cannot be traded only the attempts to replicate it.  For assets that are not tradable, derivatives can be ""cash settled"" where the value of the underlying is delivered in cash.  Cash settlement can be used for underlyings that in fact due trade but are frequently only elected if the underlying is costly to deliver or there is an incentive to circumvent regulation. Currently, only futures that settle on the value of the VIX at the time of delivery trade; in other words, VIX futures holders must deliver on the value of the VIX in cash upon settlement.  Options in turn trade on those futures and in turn are also cash settled on the value of the underlying future at expiration. The VXX ETF holds one to two month VIX futures that it trades out of before delivery, so while it is impossible to know exactly what is held in the VXX accounts unless if one had information from an insider or the VXX published such details, one can assume that it holds VIX futures contracts no later than two settlements from the preset.  It should be noted that the VXX does not track the VIX over the long run because of the cost to roll the futures and that the futures are more stable than the VIX, so it is a poor substitute for the VIX over time periods longer than one day. ""Underlying"" now implies any abstract from which a financial product derives its value." "I thought the other answers had some good aspect but also some things that might not be completely correct, so I'll take a shot. As noted by others, there are three different types of entities in your question:  The ETF SPY, the index SPX, and options contracts. First, let's deal with the options contracts.  You can buy options on the ETF SPY or marked to the index SPX.  Either way, options are about the price of the ETF / index at some future date, so the local min and max of the ""underlying"" symbol generally will not coincide with the min and max of the options.  Of course, the closer the expiration date on the option, the more closely the option price tracks its underlying directly.  Beyond the difference in how they are priced, the options market has different liquidity, and so it may not be able to track quick moves in the underlying. (Although there's a reasonably robust market for option on SPY and SPX specifically.) Second, let's ask what forces really make SPY and SPX move together as much as they do.  It's one thing to say ""SPY is tied to SPX,"" but how?  There are several answers to this, but I'll argue that the most important factor is that there's a notion of ""authorized participants"" who are players in the market who can ""create"" shares of SPY at will.  They do this by accumulating stock in the constituent companies and turning them into the market maker.  There's also the corresponding notion of ""redemption"" by which an authorized participant will turn in a share of SPY to get stock in the constituent companies. (See http://www.spdrsmobile.com/content/how-etfs-are-created-and-redeemed and http://www.etf.com/etf-education-center/7540-what-is-the-etf-creationredemption-mechanism.html) Meanwhile, SPX is just computed from the prices of the constituent companies, so it's got no market forces directly on it.  It just reflects what the prices of the companies in the index are doing. (Of course those companies are subject to market forces.) Key point: Creation / redemption is the real driver for keeping the price aligned.  If it gets too far out of line, then it creates an arbitrage opportunity for an authorized participant.  If the price of SPY gets ""too high"" compared to SPX (and therefore the constituent stocks), an authorized participant can simultaneously sell short SPY shares and buy the constituent companies' stocks.  They can then use the redemption process to close their position at no risk.  And vice versa if SPY gets ""too low."" Now that we understand why they move together, why don't they move together perfectly.  To some extent information about fees, slight differences in composition between SPY and SPX over time, etc. do play.  The bigger reasons are probably that (a) there are not a lot of authorized participants, (b) there are a relatively large number of companies represented in SPY, so there's some actual cost and risk involved in trying to quickly buy/sell the full set to capture the theoretical arbitrage that I described, and (c) redemption / creation units only come in pretty big blocks, which complicates the issues under point b. You asked about dividends, so let me comment briefly on that too.  The dividend on SPY is (more or less) passing on the dividends from the constituent companies. (I think - not completely sure - that the market maker deducts its fees from this cash, so it's not a direct pass through.)  But each company pays on its own schedule and SPY does not make a payment every time, so it's holding a corresponding amount of cash between its dividend payments.  This is factored into the price through the creation / redemption process.  I don't know how big of a factor it is though." The question is always one of whether people think they can reliably predict that the option will be a good bet. The closer you get to its expiration, the easier it is to make that guess and the less risk there is. That may either increase or decrease the value of the option. "The strategy is right. As pointed out by you, will the "" volatility cause the premium on the price of the options to be too high to make this worthwhile"" ... this is subjective and depends on how the markets feels about the volatility and the trend ... ie if the market believes that the stock will go up, the option at 45 would cost quite a bit less. However if the market believes the stock would go down, the option at 45 would be quite high [and may not even be available].   There is no generic right or wrong, the strategy is right [with out without putting dividend into equation] it depends what options are available at what prices." I don't think you can always assume a 12-month time horizon.  Sometimes, the analyst's comments might provide some color on what kind of a time horizon they're thinking of, but it might be quite vague. For implied volatility it is okey to use Black and scholes but what to do with the historical volatility which carry the effect of past prices as a predictor of future prices.And then precisely the conditional historical volatility.i suggest that you must go with the process like, for stock returns  1) first download stock prices into excel sheet 2) take the natural log of (P1/po) 3) calculate average of the sample  4) calculate square of (X-Xbar) 5) take square root of this and you will get the standard deviation of your required data. "I'm reminded of a conversation I had regarding food. I used the word 'diet' and got pushback, as I meant it in sense of 'what one eats'. That's what a diet is, what you eat in an average week, month, year. That list has no hidden agenda unless you want it to. If your finances are in good shape, debt under control, savings growing, etc, a budget is more of an observation than a constraint. In the same way that my bookshelf tells you a lot about who I am, books on finance, math, my religion, along with some on English and humor, my budget will also tell you what my values are.  Edit - In a recent speech, regarding Joe Biden, Hillary Clinton said ""He has a saying: ‘Don’t tell me what you value. Show me your budget and I will tell you what you value.’ "" - nearly exactly my thoughts on this.  For the average person, a budget helps to reign in the areas where spending is too high. $500/mo eating out? For the couple hacking away at $30k in credit card debt, that would be an obvious place to cut back. If this brings you happiness, there's little reason to cut back. The budget becomes a reflection of your priorities, and if, at some point in the future, you need to cut back, you'll have a good understanding of where the money is going."