Implied Volatility- It’s All Relative

On the blog, I talk about Implied Volatility, or IV, quite a bit. It’s basically what active investors look for in order to decide which underlyings to trade.

IV is a measure of perceived future volatility (price movement) that factors into the option’s pricing (risk-reward tradeoff). IV rank is what provides context to the IV, comparing the past to the present in order to illuminate all that IV has to offer.

As an active investor, I live for the high IV environment. I get more premium from my trade (on average, collecting more money when I sell options). This is because options are more expensive, so I get a larger credit. However, if I were an option buyer, I would prefer a lower IV environment because I pay less for each option I buy. So in a high IV environment, options are pricier, which is good for option sellers (credit spreads are perfect here!) and not-so-good for option buyers.

As mentioned in my previous post on ETFs, index funds have lower IV than single stocks due to the index’s overall “largeness”. It has less risk compared to a single stock, and as such, has a lower IV.

The best way to think about the IV levels between an index and a single stock would be comparing a large basket that contains rice, cheese, bread, and pasta (an index), and a basket that only contains rice (a stock). If a certain bug suddenly struck North America, decimating all strains of rice to the point of no return, which basket would carry more risk? The basket that contains multiple assets, or the basket that contains only one?¬†Even without the bug, the rice only basket is simply riskier, because once something happens to that rice, you’re out of the game. To get rid of the multi-asset basket, bad things would have to happen to not only rice, but cheese, bread, and pasta, as well. The multiple assets keep the overall basket from changing too dramatically, whereas the single asset is subject to massive detriment if things go wrong.

So why would we ever trade an index fund over a single stock if the single stock has a higher IV? Is that not what we look for when trading?

It’s important to remember that pricing is all relative. A $1 move in underlying XYZ priced at $150 is much different than a $1 move in underlying ABC priced at $5. This is the same for IV. A 15% IVR in XYZ might be just as “high” as a 50% IVR in ABC, as compared to their respective IV ranks. This is why it’s important to look at IV relative to what it has been in the past, rather than what it currently is.

For example, if XYZ has an IV of around 15%, that seems pretty low. But when we compare it to the highest IV level for XYZ for the last 12 months, which is 7%, we can see that IV is actually high relative to where it has been, and option prices will show that. They will be more expensive. If the IVR of ABC is 50%, but the highest IV level for the past 12 months was 90%, we can see that this IV level of 50%, which looks high, is actually quite low. It’s all relative!

If you’re a formula person, the formula for IV rank is pretty easy to calculate. It’s simply:

(current IV level – 52 week IV low) / (52 week IV high – 52 week IV low) x 100 = IV Rank

So, taking XYZ, sitting at 16% currently, with a low of 7% and a high of 20%, we get an IV rank of about 70%. That means that 16% is a HIGH IV for this stock, and we should take advantage of it right away! My favorite high IV trade is the credit spread, since I am trading a smaller account, (and risk averse) but a well placed strangle or straddle would profit largely here!

IV rank is definitely something to keep in mind when trading options. As an active investor, you want to search out high IV underlyings (remember, it’s all relative to the past) and sell some premium. Even just selling a covered call to reduce your cost basis on stock you already own is a great way to take advantage of high IV environments, and a great way to begin taking control of your own finances.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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