Give yourself an edge in trading options: Use implied volatility, IV Percentile and IV Rank!
Volatility is the bloodstream of the options markets and it’s something that options traders should thoroughly be versed with.
Volatility is the bloodstream of the options markets and it’s something that options traders should thoroughly be versed with.
Volatility, in simple terms, is defined as the up & down movements of an underlying security i.e. the amount of the stock price fluctuations without regard to direction. A stock, which trades relatively stable, is said to have low volatility while a stock that is prone to sharp price movements in either direction is said to have high volatility.
Many naive option traders don’t fully understand the implication of volatility, which leads to further problems. It’s not possible to make any kind of accurate forecasts about how the price of options will move without having a clear insight into volatility and the impact it creates.
As a trader, one needs to be aware of the two types/measures of volatility, which are, historical and implied. As per Investopedia, historical volatility is defined as 'a statistical measure of the dispersion of returns for a given security or market index over a given period of time’. In addition to historical volatility, traders should also know about implied volatility (also known as projected volatility or IV). IV is an estimation of the future volatility of the underlying security. Implied volatility is a dynamic figure that changes based on activity in the options marketplace.
Why it is important to understand implied volatility? Basically, it helps us to answer the question like the options is relatively expensive or cheaper.
In the next section, we will discuss two vital methods that help an options trader to gauge how cheap or expensive an option is, as compared to its past.
- Implied volatility rank: Implied volatility rank (IV Rank) states a stock’s current IV to its IV range over a certain time period of time (usually one year). In simpler terms, IV Rank indicates whether the implied volatility ranks between the selected periods’ high and low.
Formula to calculate one-year IV Rank:
Current IV - IV Minimum (low) of the period/IV Maximum (high) of the period - IV Minimum (low) of the period *100
Example for calculating IV Rank:
Let us assume that there’s a stock named ABC, which has an implied volatility of 25 per cent with a one-year IV high & low range between 18 per cent and 38 per cent; so, IV Rank for that particular stock would be calculated as 25 – 18/ 38- 18 * 100= 35 per cent.
This gives us an IV Rank of 35 per cent, indicating that the difference between the current IV and the low IV is only 35 per cent of the entire IV range over the past one year, which means that the current IV is nearer to the low end of the historic levels of implied volatility.
- Implied volatility percentile: Implied volatility percentile (IV Percentile) tells us the percentage of days in the past that a stock’s IV was lower than its current IV. In simple terms, IV Percentile data points out the percentage of days with implied volatility closing below the current implied volatility over a given period of time.
Formula to calculate IV Percentile:
Number of days with IV lower than current IV/number of days in the chosen period * 100
Example: The current implied volatility of a stock named XYZ is at 30 per cent. Now, suppose, you want to measure IV Percentile of the last 252 days but in the last 160 days out of 252, the stock’s IV has been below 30 per cent. In this case, the stock’s 30 per cent implied volatility represents an IV Percentile: 160/252*100= 63.49 per cent.
An IV Percentile of 63.49 per cent tells us that the stock’s current IV has been below 30 per cent i.e. approximately 63.49 per cent of the days over the past year.
For an options trader, it’s essential to know IV Rank or IV Percentile while initiating an options strategy. This is because the entire concept of trading options and selecting the right strategies depends upon the concept of volatility & pricing.