Volatility Index Using Option Pricing Parameters
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Solution Overview
Problem
Existing volatility indices, such as VIX and Speth's index, fail to accurately capture actual profits and losses from volatility trading strategies due to reliance on implied volatility and lack of consideration for gamma, theta, and hedging strategies, providing a misleading picture of risk-return tradeoffs and lacking as benchmarks for real options trading.
Innovation Solution
A volatility index that calculates precise profits and losses by tracking delta, gamma, theta, and vega effects, using option pricing models to derive volatility from actual option prices, allowing for the creation of synthetic indices and financial instruments that reflect actual volatility trading outcomes.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Measurement precision
If volatility index is computed using implied volatility of options only, then the index can be calculated from market data, but it fails to reflect actual profits or losses from volatility trading strategies
Solution Approach 1:
The patent transforms the volatility index calculation from using only implied volatility to incorporating multiple option pricing parameters including gamma, theta, and vega. This parameter expansion allows the index to reflect actual trading profits and losses by capturing the nonlinear effects that pure implied volatility measurements miss.
2Ease of manufacture
If volatility index is based on implied volatility, then it can be derived from option prices, but it does not reflect actual profits or losses from real options trading
Solution Approach 1:
The patent introduces an option pricing model as an intermediary framework that connects market-observable option prices to the underlying volatility parameters. By using models like Black-Scholes or Binomial models, the system derives gamma, theta, and vega from option prices, enabling calculation of actual trading P&L while maintaining ease of computation from market data.
3Adaptability or versatility
If volatility index uses weighted average of out-of-the-money options, then it can be constructed from available options, but it fails to provide accurate profit or loss numbers for volatility trading
Solution Approach 1:
Instead of constructing volatility from option prices as prior art does, the patent inverts the approach by using option pricing models to extract the implied volatility parameters (gamma, theta, vega) from option prices, then using these parameters to calculate actual trading outcomes. This inversion transforms the measurement from a direct aggregation of option prices to a model-based derivation of underlying volatility characteristics.
4Reliability
If active subjective management is used to improve risk adjusted returns on volatility, then returns may be enhanced, but future realized volatility is not predictable in the long term
Solution Approach 1:
The patent creates a volatility index that serves itself as a benchmark without requiring external subjective management. By capturing actual trading P&L through gamma, theta, and vega effects, the index automatically reflects market volatility conditions and provides an objective performance measure that does not rely on manager predictions or subjective judgments about future volatility.
Data Source
AI summary
A system for and method of tracking and investing volatility is disclosed. The system and method may be used to commodify the volatility of any set of assets. The system and method may include a financial instrument that allows an investor to take a view on volatility.