Option Trading Blog

One of the most important tools for the option trader are the Parkinson number and the Variance Ratio Method. The Parkinson number, named after physicist Michael Parkinson, is an estimator of the volatility of returns presupposing that returns follow a geometric random walk (If that last bit doesn’t tell you anything, don’t worry).

If you take a look at the last post when we estimated volatility, we needed to take a sample of each day/week/month we wanted to estimate. The Parkinson method estimates the volatility only by the high and low of any particular period. Following is the formula. Don’t worry if it looks scary, I’ll walk you through it:

Where and are the High and Low for that period respectively.

The meaning

If this number is supposed to give us the estimated volatility, we can compare it to the sampling formula we derived in the post about volatility estimation. This gives us the following relation:

Where is the sampled volatility we estimate.

This last equation tells us that the Parkinson number will be 1.67 times bigger than the sampled volatility.

Why Should You Care

Who cares really you ask? We are interested in the cases when the Parkinson number is either bigger or lower than 1.67 times the volatility. When The Parkinson Number is higher than 1.67 times the volatility, it means that the markets are volatile and one should follow a trend. This is just one application. You can think of many more applications when you know volatility is high.

Another application is with hedging. If the Parkinson Number is lower, than we can assume the market is less volatile and hence, perhaps not re-balance our hedge to keep ourselves market neutral.

I’ll soon add an excel file so you could implement this on your own. I’ll also add some application with the Parkinson number so you could see how good of an indicator it is. Also, in the next post, I’ll discuss the Variance-Ratio Method and how it can help you profit in your trades.