By: Steve Smith
We just came through one of the quietest, least volatile periods in stock in history, in which the S&P 500 Index went 45 days with a move of 1% or more. This caused the VIX to sink down to the 11 level and the 30-day historical volatility to a minuscule 5.2% last week.
And then volatility exploded, a market resolved the narrow range to the downside as the S&P dropped some 2.2% on Friday. We have now had three consecutive session of 1%+ moves and the VIX has jumped some 40% to the 19% level.
What sometimes gets lost in the broad discussion of VIX and general volatility levels when these big moves occur are the specifics of how implied volatility gets factored into option pricing and impacts our trading. So this a good time to review some basic concepts.
Implied volatility is one of the most important concepts when trading options. In this article, we’ll try to understand a little bit more why it is important and how to use it when trading to increase our profits. Implied volatility is a ‘plug number’ (a placeholder number used to make the calculation estimate correct), used to make the result from the Black and Scholes formula equal to the market price. IV has major impact on trading, and to simplify this idea, let’s look at an example:
Stock A is priced at $100 and has high implied volatility. Let’s say that the call strike 100 costs $4.
Stock B is also priced at $100 but has low implied volatility. Let’s say that the call strike 100 costs $1.
When comparing the two trades, we can see that the break even point of stock A is $104 and for stock B is $101. This means that we have an increase of 1% to show profit in stock B, but 4% in stock A. Furthermore, if we assume a similar increase, let’s say 5% in each stock (by expiration) – we can see that we will have $1 profit in stock A but a $4 profit in stock B. The following Table summarizes the two scenarios:
Compare high and low implied volatility scenarios.
To put it simply: When IV is low it’s easier to profit and your profits are higher (for buyers) and when IV is high it is harder to profit and the profit is lower. Of course, it is vice-versa for option sellers.
Sometimes, however, higher IV is justified – mainly due to stock volatility/conditions or market conditions. For example: NFLX volatility is twice as high (when compared in percentage) compared to WMT. We can expect the IV and the options premium to reflect that as well.
An analogy could be done to the PE ratio – most of the time a company deserves a high or low PE ratio. But when it’s extreme it usually is a contrarian sign.
So, how do we know if IV is high or low? and more importantly – How do we know if the odds are in our favor? We can use IV Percentile (Rank)
IV Rank (percentile) is a measurement of stock IV. For example: If a stock has IV Rank of 92.5%. This means that over the last 200 days 92.5% of the days had lower IV than the current one. Or to put it simply: The current IV is high.
These calculations have several characteristics:
- It is fluctuating between 0-100
- It is mean reverting (after a high value you can expect a lower value in higher probability)
- If the IV rank is high – it is more favorable towards options selling.
- If the IV rank is low – it is more favorable towards options buying.
Right now we are in an interesting place; volatility is relatively high compared to where it was one and two months ago but it is far from an extreme. My gut tells me volatility continues to lift over the next few weeks, meaning it’s probably OK to buy options to take advantage of more and larger price swings.