Measuring implied volatility: Is an average better? Which average?

Options researchers have argued that by averaging together implied standard deviations, or ISDs, calculatedfrom several options with the same expiry but different strikes, the noise in individual ISDs can be reduced,yielding a better measure of the market's volatility expectation. Various options researchers have suggesteddifferent weighting schemes for calculating these averages. In the forecasting literature, econometricians havemade the same argument but suggested quite different weighting schemes. Ignoring both literatures, commercialvendors calculate ISD averages using their own weightings. We compare the averages proposed in both the optionsand econometrics literatures and the averages used by major commercial vendors for the S&P 500 futuresoptions market. Although some averages forecast better than others, we find that the question of the bestweighting scheme is of secondary importance. More important is the fact that the ISDs are upward biased measuresof expected volatility. Fortunately, this bias is stable over time, so past bias patterns can be used to obtainunbiased volatility forecasts. Once this is done, most ISD averages forecast better than time series and naivemodels, and the differences between the averages produced by the various proposed weighting schemes are small.© 2002 Wiley Publications, Inc. Jrl Fut Mark 22:811–837, 2002