Option Trading: Pricing and Volatility Strategies and Techniques

CHAPTER 7

Volatility Estimation

Although it is always perilous to assume that the future will be like the past, it is at least instructive to find out what the past was like. Experience suggests that for predicting future values, historic data appear to be quite useful with respect to standard deviations, reasonably useful for correlations, and virtually useless for expected returns.

—William Sharpe, “Asset Allocation,” in John L. Maginn and Donald L. Tuttle, eds., Managing Investment Portfolios: A Dynamic Process, 2nd ed. (New York: Warren, Gorham & Lamont, 1990)

 

 

It is generally accepted by academics that asset returns are unpredictable. This is the basis for the efficient market theory. Here we will not get into the long-running and contentious arguments over the degree of correctness of this theory, except to note that they can quickly take on aspects of debates between atheists and religious fundamentalists.

My view is that the theory is correct in the same way that the theory that the earth is spherical is correct. The earth is not perfectly spheroid, but from a sufficient distance it looks spherical. The planet’s bumps and irregularities are small and the idea of a spherical earth is a far better descriptive theory than the one it replaced, the idea that the earth was flat. Using the spherical earth theory has allowed us to do many useful things such as flying around the world. However, a pilot who blindly believed in the theory would put us in grave danger: his theory ...