Most tastytraders are well aware that Implied Volatility Rank (IVR) can be a helpful metric when filtering for volatility-based trading ideas.
As a reminder, IVR tells us where current implied volatility in a given symbol ranks as compared to the last 52 weeks of data.
So if hypothetical symbol XYZ traded with an implied volatility between 30 and 60 over the last 52 weeks, then an implied volatility of 45 in XYZ would equate to an IVR of 50%. Likewise, if implied volatility in XYZ was 60, then IVR would be 100%.
Generally speaking, here at tastytrade we look for opportunities to sell premium when IVR is above 50%, and for opportunities to purchase premium when it's below 50%.
A recent episode of Market Measures takes a deeper look at IVR, particularly as it relates to the rolling 52-week nature of the data.
Because IVR includes only the last 52 weeks of implied volatility data, that means IVR itself is basically a rolling 52-week window. On one hand, this is appropriate because we are more interested in knowing what implied volatility has done in XYZ recently, as opposed to a trading period that may have contained far different conditions.
For example, how much value is there in comparing the implied volatility of a symbol during the financial crisis (one of the most volatile periods in trading history) to the implied volatility of today (one of the less volatile periods in recent memory)? The answer is, not much.
On the other hand, being cognizant of the data you are using to make trading decisions is also very important.
From this perspective, it can help at times to take a bird's-eye-view of implied volatility, to ascertain how today's overall environment compares to other periods in a given symbol's history. That perspective can help us better understand what is often referred to as the "vol of vol" - the volatility of the volatility itself.
The chart below shows the implied volatility of the VIX from 2005 to present, which illustrates how volatility itself tends to trade within varying ranges:
As you can see from the above graphic, the implied volatility range of VIX during the period that encompassed the Financial Crisis was an eye-popping 64.6 points wide. Looking at that range over the last couple years, the width narrows considerably to only 13.2 points.
Estimating the median implied volatility range for the entire period (2005 to present), we arrive at a number closer to 17.
Given that the VIX has hovered around 10 for much of the time since Donald Trump was elected President, it's certainly not a shock to think that the implied volatility range for any given symbol is on the lower end of its historical spectrum at the present time.
The question then, is what impact these ranges might have (if any) on potential returns? For example, is it more profitable to sell volatility when IVR is near its zenith in a higher range, as compared to selling it at its zenith in a lower range?
Fortunately, research presented on the aforementioned episode of Market Measures provides information that helps answer that question.
In particular, tastytrade designed a backtest that compared two different historical strategies. Both strategies focused on selling strangles when IVR was above 50%. However, one strategy focused on periods in history when implied volatility ranges were narrow, while the other encompassed periods in history when implied volatility ranges were wider.
The results of this analysis are presented in the chart below (data is from 2005 to present):
As illustrated above, both strategies produced attractive win rates that were above 80%. However, the average PnL dipped for the strategy that focused on selling premium in implied volatility environments with tighter ranges.
Depending on your own unique approach, the information contained in this episode of Market Measures may help you optimize your thinking as conditions in the market shift. When implied volatility is trading in a tighter range, there’s an argument to be made that position sizes should be smaller, giving traders added flexibility and the ability to rebalance quickly if a paradigm shift materializes.
Such thinking could also allow traders to tap unused capital if/when implied volatilities ranges expand and higher returns are potentially on the table.
We hope you’ll take the time to review the full episode of Market Measures focusing on widening the IVR lens when your schedule allows. Don’t hesitate to reach out to firstname.lastname@example.org with any questions.
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.