While options are priced in dollar and cents in the marketplace, these values can be reverse engineered to calculate a market value in volatility terms. The resulting calculation is called "implied volatility," and represents the market's expectation for future movement in the price of a given underlying.
Looking at an example, imagine that implied volatility in SPY is 20%. That means that over the next year, SPY is expected to close between 20% up and 20% down from today's price. According to standard deviation theory, this has a 68% chance of occurring.
While the above illustrates how traders can identify the current price of volatility, how then can assessments be made about whether this value is cheap, expensive, or fair?
Here at tastytrade, we devised a metric that can help traders makes assessments about value when it comes to the price of a given option. Known as Implied Volatility Rank (aka IV Rank or IVR), the purpose of this metric is to tell us how current implied volatility stacks up to the previous 52 weeks of data in a given underlying.
For example, if XYZ has had an implied volatility range between 30 and 60 over the past year, and implied volatility is currently trading at 45, XYZ would have an IV Rank of 50%.
If implied volatility were currently trading 60 in XYZ, then IV Rank would be 100%, indicating that implied volatility in XYZ was trading at a level equal to the richest observed in the last 52 weeks.
But why should traders care about implied volatility in the first place? After all, aren't we trading dollars and cents in the marketplace? The answer to this question hinges on mean reversion.
In the options marketplace, extreme levels of implied volatility are usually associated with two different risk environments - complacency and fear. During periods of complacency, implied volatility typically declines, depending on the degree of complacency. But when fear picks up, implied volatility usually follows - ticking higher.
Because implied volatility is historically observable, it's possible to identify the mean level (or average) in implied volatility over a given period of time. The constant shift between complacency and fear in the marketplace is why we see implied volatility consistently tracking back toward its mean.
The S&P 500 has a dedicated metric known as the VIX that reports on implied volatility in the options of the index. The mean in the VIX since its inception is about 19, which means that the VIX is constantly reverting back and forth across this important number, as you can see in the graphic below:
Tying together all of the above, one can see how trading volatility (which is proven to mean revert) is an attractive proposition when compared to trying to consistently choose the correct direction in a given underlying. The latter approach has a 50-50 probability of success.
Circling back to IV Rank, the metric is extremely useful because each and every underlying has its own range for implied volatility. Instead of looking at an arbitrary value for implied volatility, it’s a lot more informative to know how current levels of implied volatility compare to past history in a given underlying - especially when evaluating whether something is expensive, cheap, or fair.
Such assessments simply can’t be made by simply looking at the current level of implied volatility, or through the dollar and cents value of an option, for that matter.
So now we know what implied volatility is and how IV Rank can provide important insight on prices in the marketplace. But how do we practically apply IV Rank to trading opportunities?
At tastytrade, we’ve conducted extensive research on the performance of selling premium (i.e. volatility) when IV Rank is above 50%. Generally speaking, this approach produces far superior results as compared to selling volatility when IV Rank is below 50%. The same can be said when comparing an approach that sells premium when IV Rank is above 50% as compared to a blanket approach that includes “all occurrences.”
While that speaks to short volatility, what about the flip side of the coin - buying premium? Do historical backtests prove that buying premium when IV Rank is less than 50% also show consistently high win rates? The short answer, unfortunately, is no.
The complication when purchasing premium is that a trader who is long options will constantly be fighting against time decay. Even if implied volatility is low at the time of trade deployment, and "reverts" higher, that benefit can be cancelled out by the passing of time and the associated decay in value.
This is where the theoretical value of an option becomes paramount. A huge component of an options value is known as extrinsic value, which is often referred to as time value. Because options have finite lives, they theoretically lose value with each passing day.
It’s this natural decay in value that long premium traders are fighting against. And a big reason why low IV Rank (<50%) hasn’t proven to be an effective trading signal when backtesting historical data.
If you want to learn more about IV Rank and mean reversion, we recommend reviewing two new episodes of Best Practices that focus on this important subject (listed below). Additionally, links are included which highlight previous tastytrade research on the success rates of selling premium when IV Rank is above 50%, and buying premium when IV Rank is below 50%:
We look forward to hearing from you!
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.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.