A Simple Formula to Compute the Implied Standard Deviation
Author(s): Menachem Brenner and Marti G. Subrahmanyam
Source: Financial Analysts Journal , Sep. - Oct., 1988, Vol. 44, No. 5 (Sep. - Oct., 1988),
pp. 80-83
Published by: Taylor & Francis, Ltd.
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Equation (7) is developed on the assumption that Footnotes
valuation takes place on a dividend payment date.
1. See E. F. Brigham, Financial Management. Theory
In order to illustrate how calculated values can
and Practice, 4th ed. (New York: The Dryden
differ between the three-phase quarterly model and
Press, 1985), pp. 176-179, and C. M. Linke and
three-phase annual model, consider a growth stock
J. K. Zumwalt, "Estimation Biases in Discount-
with the following attributes:
ed Cash Flow Analysis of Equity Capital Cost in
gi = 0.30, Rate Regulation," Financial Management, Au-
g2 = 0.50, tumn 1984, pp. 15-21.
Ql = 0.65, 2. The author is indebted to Russell J. Fuller for
T = 5, showing him that D1 can be expressed in the
Do= $2.00, form of Equation (6) in the quarterly model.
k = 0.15 and 3. See, for example, R. J. Fuller, "Programming the
N= 10. Three-Phase Dividend Discount Model," Journal
of Portfolio Management, Summer 1979, pp. 28-
With the annual model, value, or price, equals 32, and R. W. Taylor, "Make Life Easy: Bond
$103.50. With the quarterly model, the calculated Analysis and DDM on the PC," Journal of Portfo-
price equals $109.15. lio Management, Fall 1985, pp. 54-57.
A Simple Formula to Compute emphasized, however, that ISDs from options with
different maturities should not be combined to pro-
the Implied Standard Deviation vide a single estimate, because they may reflect
by Menachem Brenner, New York University and He- different perceptions on short-run versus long-run
brew University, and Marti G. Subrahmanyam, New volatility, a kind of "term structure of volatility."
York University' Because the ISD does not have a closed-form solu-
tion, the practice has been to use a numerical proce-
One of the most widely used applications of the dure such as the Newton-Raphson method.5 Not
Black-Scholes (BS) option-pricing model is the estima- only does every study on ISDs use the Newton-
tion of the volatility, or standard deviation, of the rate Raphson method or a variant of this procedure, but
of return on the underlying asset, using the market this is also the method employed in most software
prices of the option and the asset. The implied packages.
standard deviation (ISD) is the estimate of the volatili- There is, however, a much simpler procedure that
ty that perfectly explains the option price, given all does not require any iterative search and yet provides
other variables, including the price of the underlying reasonably accurate estimates of ISDs. Like the stan-
asset in the context of the BS model. dard BS model, the formula is most accurate if used
Latane and Rendleman published the first paper for at-the-money European call options (such as op-
dealing with this estimate.1 To reduce sampling error tions on the S&P 500 or the Institutional Index or
in their estimates, they proposed a weighting scheme American call options with no dividends left to expi-
that gives more weight to at-the-money, longer- ration).
maturity options. Since then, the ISD has been sub- The Black-Scholes formula for stock options is as
jected to more detailed investigations into its proper- follows:
ties and its relationships with other estimates of
volatility. It has also been used increasingly as a tool C = S N(d1) - Kert N(d2) (1)
for testing the validity of the BS model and for
where
designing options trading strategies.2
In the past few years, it has been recognized that
in (S/Ker{) + 1/2 o&2 t
the best estimates of volatility are obtained from at-
the-money options.3 The main reason is that at-the-
money options are almost always the most actively and
traded options and suffer the least from measurement
errors, which arise mainly from nonsimultaneity in d2 dI - cV_.
reported prices and the bid-ask spread.4 It should be In the above equation,
Cs = the price of the call option on the stock,
1. Footnotes appear at end of article. S = the stock price,
K = the striking price,
* The authors thank Sang Park, Mark Rubinstein ani r = the annual rate of interest compounded
William Silber for their helpful comments. continuously,
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1988 D 80
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t = the time to expiration, mation errors when the option is not exactly at-the-
= the standard deviation of the instantaneous money. There is, however, a simple remedy: Use the
rate of return on the stock on an annual value of the straddle (i.e., the put and call option
basis and taken together), rather than the call or the put option
N(.) = the cumulative standard normal density only, to compute the ISD. For striking prices that are
function. about 5 per cent apart, as in a typical case, the value
of a straddle between two neighboring striking prices
For our purpose, an at-the-money option on a spot
is almost the same as the value of the straddle at the
instrument is defined as one whose striking price is
closest striking price.7 For at-the-money options on
given by S = Kert. As the appendix shows, the value
the spot, the value of a straddle is given by:
of an at-the-money call will be:
STRS = Cs + PS = 2 [0.398 a Vfi S]. (5)
Cs = 0.398 Kert orVt = 0.398 S o- Vi. (2)
Therefore, the ISD is given by:
Therefore the ISD is given by:
as = 1/2 STRS/(0.398 VI S). (6)
C = (CS/S) x (1/0.398 Vt) . (3)
For example, on February 17, 1988, the closing prices
For example, if:
for IBM and for the March/115 options were:
S= 49.25,
S= 112.75,
K = 50,
K= 115,
t= 0.25,
r = 0.06 and CPCss= =3,
4.75
C = 5.25, s
t= 0.082,
then, using Equation (3): r= 0.06.
c = (5.25/49.25)/(0.398 0.25) Using Equation (6), we obtain:
= 0.54.
o- = 0.5(3+4.75)/(0.398 0.08 x 112.75),
A formula similar to Equation (3) can be used for cr= 0.30.
European call options on futures contracts when at-
This estimate is reasonably accurate even when we
the-money options on futures are defined as those for
use the price of a straddle that is not exactly at the
which F = K, where F is the futures price. In that
money, because within a certain range, the increase
case:
in the call (put) value is matched by a similar decrease
Cf = 0.398 Ke"rt 0- Vi = 0.398 Fe-rt 0V i, (4) in the put (call) value. The accuracy of this approxi-
mation depends on the value of - it. With larger
where Cf is the value of the call option on the futures
values, the price of the straddle can deviate from the
contract. The implied volatility equation is, therefore,
money by larger amounts and the equation will still
the same as for stock options with the definition of yield reasonably accurate estimates of volatility.
"at-the-money" being F = K. For example, if
Table I presents the accuracy of our estimate as a
F = 250, function of a Vti and S/Ker . When o- Vi equals 15
K = 250, per cent, we can use straddles that are between -5
t = 0.167, and + 3 per cent away from the money and the error
r = 0.06 and in the ISD should still be less than 1/2 per cent-the
Cf 12.5, typical bid-ask spread.8 This is well within the range
of striking prices available for actively traded options.
then: For example, the striking prices for the S&P 100
options change by five points for levels in the 250 to
fo = (12.5/247.5)/(0.398 0.167)
330-point range.
= 0.31.
The approximation may also be used to generate a
A modified version of this formula can also be good starting point for the more accurate Newton-
applied to estimate the volatility of European foreign Raphson procedure to compute the ISD. Manaster
currency options where the definition of "at-the- and Koehler state that a good starting guess is useful
money" relates the present value of the foreign in improving the speed of convergence.9 The starting
currency in units of the domestic currency, using the value they provide converges to a positive implied
foreign interest rate, to the present value of the volatility.10 It is purely a function of the option's
striking price, using the domestic interest rate.6 depth in the money and not related to an approxima-
In reality, the price of the underlying asset is rarely tion of the volatility. In other words, two options on
exactly equal to the present value of the striking the same stock, which differ by the exercise price,
price, and the formula may produce nontrivial esti- may have radically different starting values. In con-
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1988 O 81
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Table I Implied Standard Deviations (per cent)
S/K eirt 5% 10% 15% 20% 25% 30% 35% 40%
0.90 12.61 14.32 17.60 21.53 25.75 30.11 34.55 39.03
0.91 11.42 13.50 17.04 21.14 25.48 29.93 34.44 38.98
0.92 10.26 12.75 16.55 20.80 25.25 29.79 34.36 38.96
0.93 9.17 12.08 16.12 20.52 25.06 29.68 34.32 38.96
0.94 8.15 11.49 15.75 20.28 24.92 29.60 34.30 38.99
0.95 7.24 11.00 15.46 20.10 24.82 29.56 34.31 39.05
0.96 6.45 10.60 15.23 19.97 24.76 29.55 34.35 39.14
0.97 5.81 10.30 15.06 19.89 24.74 29.59 34.42 39.27
0.98 5.35 10.10 14.97 19.87 24.76 29.65 34.53 39.38
0.99 5.08 10.00 14.94 19.89 24.83 29.75 34.66 39.54
1.00 4.99 9.99 14.98 19.96 24.93 29.88 34.82 39.73
1.01 5.12 10.10 15.09 20.09 25.07 30.05 35.01 39.94
1.02 5.44 10.29 15.27 20.26 25.26 30.25 35.22 40.18
1.03 5.94 10.59 15.51 20.49 25.48 30.48 35.46 40.44
1.04 6.59 10.97 15.80 20.76 25.75 30.74 35.74 40.72
1.05 7.39 11.44 16.17 21.07 26.04 31.04 36.03 41.02
1.06 8.30 11.99 16.58 21.43 26.37 31.36 36.35 41.35
1.07 9.30 12.62 17.06 21.83 26.74 31.71 36.71 41.70
1.08 10.38 13.33 17.59 22.28 27.15 32.09 37.08 42.07
1.09 11.51 14.10 18.17 22.77 27.58 32.50 37.48 42.47
1.10 12.68 14.92 18.80 23.29 28.05 32.94 37.90 42.88
trast, our procedure focuses on a good starting guess of d,. Therefore:
of the volatility and is independent of the effect of the
depth in the money. It is obvious, therefore, that in N(dd) - 1/2 + 0.398 d =0.5 +
0.199 OVi, (A3)
almost all cases our procedure will provide a starting
value that is closer to the final value of the volatility N(d2) = 1 - N(d1) = 0.5 - 0.199 of Vfi . (A4)
than the Manaster and Koehler procedure. The value of an at-the-money call will then be:
We hope that our simple formula will help in
developing a better intuitive understanding of the Cs = 0.398 S - 't . (A5)
complex relationship underlying the BS model. It can
be used, for example, to illustrate the fact that there
are two components of the value of an option. One is
related to the depth in the money and the other to the Footnotes
impact of volatility. For an option that is close to the
1. H. Latane and R. Rendleman, Jr., "Standard
money, the value is determined almost entirely by Deviations of Stock Price Ratios Implied in Op-
the volatility factor in an approximately proportional tion Prices," Journal of Finance, May 1976, pp.
relationship, as given by Equation (2). 369-381. A working paper by R. Reback and W.
Sharpe ("Estimation of Market Uncertainty Based
Appendix on Option Prices"), written around that time,
For at-the-money options, the Black-Scholes for- was never published.
mula, given by Equation (1), can be simplified as 2. For tests of the ISD and BS model, see, for
shown below. Define at-the-money as S = Ker, then example, S. Beckers, "Standard Deviations Im-
d and d2 in Equation (1) are: plied in Options Prices as Predictors of Future
Stock Price Variability," Journal of Banking and
d = 1/2 oV t,
Finance, September 1981, pp. 363-382; M. Bren-
d2 = - 1/2 (X<. (Al)
ner and D. Galai, "On the Prediction of the
Because:"1 Implied Standard Deviation," Advances in Futures
and Options Research 2 (Greenwich, CT: JAI Press,
N (d) =1/2 + 12/ d 6 1987); M. Rubinstein, "Nonparametric Tests of
Alternative Option Pricing Models Using all Re-
ported Trades and Quotes on the Thirty Most
Active CBOE Option Classes from August 23,
2 .. (A2) 1976 through August 31, 1978," Journal of Finance
2! 2 .5
40 (1985), pp. 445-480; and J. Macbeth and L.
Merville, "An Empirical Examination of the
we can ignore all the terms beyond d, for small values
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1988 O 82
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Black-Scholes Call Option Pricing Model," journal currency options. The term S in Equation (1) is
of Finance, September 1979, pp. 1173-1186. replaced throughout by Se-dt for the case of a
3. For example, J. Cox and M. Rubinstein (Options continuous dividend at the annual rate d. For
Markets (Englewood Cliffs, NJ: Prentice-Hall, foreign currency options, S is replaced through-
1985)) discuss the weighting scheme employed out by Se-r*t, where r* is the foreign interest rate.
by Latane and Rendleman and emphasize the The definitions of being at-the-money change,
importance of using data on at-the-money op- accordingly, to:
tions. Also, options services such as The Options
Group (TOG) use at-the-money options to com- Se-dt = Kert
pute the ISD.
4. Combining these estimates with out-of-the-mon- and
ey estimates that contain larger errors will intro-
duce more noise rather than reduce noise. In Ser r*t = Ke-rt
addition, the ISDs for out-of-the-money options
may differ from those for at-the-money options 7. This, of course, does not hold when we are very
because the tail of the distribution may not be close to the expiration date of the option and/or
consistent with the assumption of a lognormal at extremely low values of volatility. The reason
diffusion in the BS model. is that the effect of depth in the money is (rela-
5. S. Manaster and G. Koehler ("The Calculation of tively) larger in these cases.
Implied Variances from the Black-Scholes Model: 8. The value corresponds, for example, to a three-
A Note," Journal of Finance, March 1982, pp. 227- month option on a stock with a 30 per cent
230) propose an algorithm that provides a start- annual standard deviation.
ing value for the first iteration of the Newton- 9. "The Calculation of Implied Variances," op. cit.
Raphson procedure and converges monotonical- 10. This follows from the monotonicity of the option
ly to the implied variance. value as a function of volatility, as long as option
6. The BS formula for European stock options can prices satisfy the standard boundary conditions.
be easily modified to incorporate the effect of 11. See M. Kendall and A. Stuart, The Advanced
dividends for stock options or, equivalently, the Theory of Statistics Vol. 1 (London: Charles Griffin
effect of the foreign interest rate for foreign & Co., 1943), p. 143.
There is a Free Lunch most volatility. Bonds fall below this line, however;
they have provided an inferior return, given their risk
by A.L. Pakkala, Managing Director, Property Financ-
level.
ing Corporation*
Research done by Goldman Sachs strongly sug-
gests that the volatility of straight fixed income in-
There is a superior alternative to standard fixed
struments has increased significantly in recent years,
income portfolio management. This alternative is
further reducing their relative attractiveness.' As
"barbelling" convertible debentures with low-volatili-
Figure B shows, bond volatility has achieved rough
ty, short-term government securities
parity with stock volatility during the last several
years. Several factors suggest a continuation of this
Market Environment
trend:
Figure A portrays total rates of return for bonds,
bills and stocks during much of the twentieth centu- * Debt levels throughout the international eco-
ry. U.S. bond returns represent the Standard & nomic system have increased enormously during
Poor's index from 1900 to 1973; the Shearson Lehman the last decade; financial leverage has increased
long-term, high-quality government-corporate index accordingly. The severity of future recessions is
is used thereafter. likely to exceed historical norms for this reason.
The differences are readily apparent and not gener- * A low level of domestic savings and greater
ally surprising. Treasury bills have offered the small- dependence on foreign capital increase economic
est returns but involve the least risk. Stocks are at the and interest rate volatility; foreign investment is
other end of the spectrum-greatest returns and more conditional than internal demand (and is
also sensitive to exchange rate changes).
* Persistent dollar weakness engendered by a
1. Footnotes appear at end of article.
structural trade deficit perpetuates U.S. depen-
*The author thanks Cici Tiqui and Mitchell Frank and his dence on external support of domestic debt issu-
operations staff for their support in the preparation of this ance and tilts the secular rate of inflation upward;
paper. imports cost more and export prices rise with
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1988 D 83
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