Pelman08


Total Posts: 5 
Joined: Aug 2019 


Hello I am interested in portfolio optimization . Previously I when I have done portfolio optimization I would take the historical returns of a stock and use them to perform a mean variance optimization, however I was just recently introduced to the idea of using the implied volatility of options to perform a mean variance optimization because option implied volatility is forward looking unlike historical volatility . I would like to know if I were to use implied volatility to solve this problem how would I go about doing this . Would I take the for example one year of future volatility of different stocks and put that into a mean variance optimization instead of taking the historical returns of different assets and putting them into a mean variance optimization problem ?





A key aspect of modern portfolio optimization is that you're going to have some sort of covariance matrix of stocks, usually estimated from lower rank factor exposures and residual volatilities sourced from a risk model. This way you're not just optimizing based on which names are more or less volatile, but also which names can offset each other's systematic exposures.
The problem I see with the option IV version is that you would lose this covariance information and only have a single IV as your input for each stock. Perhaps you can use option IV as some sort of input in a larger risk model, but as your only source of info, it would leave a lot to be desired. 


TonyC

Nuclear Energy Trader

Total Posts: 1326 
Joined: May 2004 


volmat*correlationmat*volmat = covariancemat
so take your historic covariance matrix turn it into a historic correlation matrix and then define volmat with zeroes above and below the diagonal with implied volatilities down the diagonal
multiply through, and you have a new covariance matrix reflecting implied volatility instead of historic volatility 
flaneur/boulevardier/remittance man/energy trader 


Jurassic


Total Posts: 293 
Joined: Mar 2018 


"going to have some sort of covariance matrix of stocks, usually estimated from lower rank factor exposures and residual volatilities sourced from a risk model"
@Its Grisha do you have any lecture notes or papers where I can read about this? 


doomanx


Total Posts: 38 
Joined: Jul 2018 


@Jurassic take a look at High Dimensional Covariance Matrix Estimation Using a Factor Model  Fan, Fan & Lv. 


