Published August 25, 2008

WARRANT INSIGHTS
What exactly do volatility figures mean?

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PROBABLY the most common word investors will come across when trading warrants is volatility. Unfortunately, although many people know it equates with risk and have a vague idea that it can be quantified using statistics, they are not entirely clear about its precise meaning.

In the world of options and warrants there are two kinds of volatility - historical and implied. Rather than describe either type, this week we'll look at how both are measured.

Volatility is measured using a statistical concept known as the standard deviation.

In statistics, large numbers of observations, if plotted on a graph, are often assumed to form a bell-shaped curve, or are said to be normally distributed around the mean or average.

The standard deviation measures the variability of the curve. The narrower or thinner it is, the less the standard deviation and the less the risk. The fatter or flatter the curve, the wider the standard deviation and the greater the risk.

This much should be relatively simple, but the question then arises: How far back should we go if we're trying to measure historical volatility?

There are no hard and fast rules, but generally the time chosen should not be so far back to include irrelevant events, or so short as to result in too few observations.

Suppose now you are told that the historical volatility of a stock is 32 per cent. What exactly does this mean?

If the stock's returns are normally distributed, statistics tells us there is a 68 per cent chance that the actual return will fall between plus/minus one standard deviation, and a 95 per cent chance it will be between two standard deviations.

As a result, 32 per cent volatility means that assuming the stock's volatility remains the same as in the past, there is a 68 per cent chance that a year from now, the return will fall between -32 and +32 per cent, and a 95 per cent chance it will be between -64 and +64 per cent.

Of course, the past is often no guide to the future - and this is where implied volatility comes in. We'll explore what this means next week.

This column is brought to you by Merrill Lynch

Please send your questions to btwar@sph.com.sg