Volatility Cone
A visual tool that shows the historical range of realised volatility at different time horizons (e.g., 10-day, 30-day, 60-day), allowing traders to assess whether current implied volatility is historically rich or cheap for a given time period.
The volatility cone was constructed using historical price data of the underlying — typically Nifty 50 or Bank Nifty — over several years. For each time horizon of interest, the analyst computed the annualised realised (historical) volatility over every non-overlapping window of that length in the historical dataset, then plotted the full distribution: the maximum, 75th percentile, median, 25th percentile, and minimum observed values. Doing this for multiple time horizons (10 days, 20 days, 30 days, 45 days, 60 days, 90 days) and overlaying the current implied volatility at each corresponding expiry produced the cone shape — wider dispersion at shorter horizons, narrower at longer ones, tapering inward.
The cone served as a relative-value framework. If the current 30-day implied volatility for Nifty was above the historical 75th percentile of realised volatility at 30 days, the option market was historically pricing volatility at a premium to what actually occurred over similar-length past periods. This was sometimes interpreted as options being expensive at that tenor, favouring premium-selling approaches. Conversely, if current IV was below the 25th percentile of the cone, options were historically cheap, potentially favouring premium buyers.
The interpretation required care. Implied volatility included a risk premium above expected realised volatility because option sellers demanded compensation for the uncertainty of their hedging costs. The fair level of this premium was not observable and varied over time. A cone comparison showed where current IV sat in a historical distribution but did not by itself tell participants whether the current premium level was appropriate.
For Indian markets, the volatility cone was particularly useful around known event periods: RBI policy announcements, Union Budget dates, and quarterly results seasons. Implied volatility historically elevated ahead of these events and collapsed immediately after — a pattern visible in the cone when comparing pre-event and post-event IV levels at short horizons.
The cone was also used in portfolio risk management to set realistic volatility assumptions for scenario analysis, anchoring forward-looking models with historical context.