While there may be different nuances as to how traders can use implied volatility when trading options, one of the most common approaches is to compare current levels of implied volatility to historical volatility.
This type of analysis provides traders with a framework for ascertaining whether current levels of implied volatility are cheap or expensive - or even just fair (neither cheap nor expensive).
At tastytrade, we developed Implied Volatility Rank (IV Rank) as a method of quickly measuring current levels of implied volatility as compared to recent history (specifically the last 52 weeks). For example, if we know implied volatility has ranged between 40 and 80 in hypothetical stock ABC over the last 52 weeks, then we can take the current level of implied volatility and compare it to those markers.
Taking the example one step further, if implied volatility is currently trading 60 in ABC, then IV Rank in ABC would be 50%. On the other hand, if implied volatility was trading 40 in ABC, then IV Rank would be 0%, and so on. When IV Rank is above 50%, we often consider selling premium.
On a new episode of Market Measures, the team takes a closer look at some of the dynamics of IV Rank in an effort to shed additional light on how traders can use the metric.
The chart below illustrates the varying levels of implied volatility in SPY over the last 52 weeks. As you can see in the graphic, implied volatility would need to jump through 24.1 in order for IV Rank in SPY to pop above 50%.
But what are some of the other trading ramifications if IV Rank does indeed go above 50%? This is one of the questions explored on Market Measures.
As you might have observed in previous research studies on the tastytrade network, rising levels of IV Rank tend to produce greater potential profits from the short premium perspective.
This is reiterated through a backtest presented on this new episode of Market Measures, which shows the average profit from a 1 standard deviation short strangle increased substantially when comparing a lower IV environment (<50%) to a higher IV environment (>50%). As an added bonus, there wasn't a huge difference in the overall success rate between the two trades.
Those findings were discovered when the team backtested a 16-delta strangle in SPY using historical data from 2005 to present, across two different volatility environments. A summary of the results is as follows:
IV Rank < 50%: 83% success rate, Average P/L $59
IV Rank > 50%: 82% success rate, Average P/L $68
With a better handle on the potential profits from both scenarios (i.e. the potential rewards), we can now take a closer look at the potential risks associated with each respective trading environment.
Because volatility has increased, that implies (pun intended) that the price range of movement in the underlying has also increased. The image below illustrates how the 1-standard deviation range in SPY gets wider when IV Rank increases:
Taking the above into account, we can now see that our risks have increased along with our potential profits. In the second half of the show, the hosts of Market Measures walk viewers through a process that quantifies how some of the risks associated with the trade have also increased.
The graphic below shows clearly how the range of our expected P/L also gets wider, along with the increasing implied volatility, which means the potential for larger losses does exist.
The above information reiterates the strong value provided by trade management approaches such as managing winners, managing losers, and rolling. By utilizing a consistent, mechanical approach to “tested” positions, traders can help reduce their exposure to larger potential losses in high volatility environments - specifically by managing losers or rolling.
We hope you’ll take the time to review the complete episode of Market Measures focusing on the IV Rank value proposition when your schedule allows. Additionally, we recommend reviewing this recent blog post - “Tested Positions: Rolling vs. Managing Losers” - if you want to learn more about trade management disciplines.
Don’t hesitate to reach out with any questions or feedback by leaving a message in the space below, or sending us a message on Twitter (@tastytade) or email (firstname.lastname@example.org).
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.