5 Must-See Studies That Explain The Importance of Implied Volatility
May 13, 2015
In the past, you’ve heard numerous segments about how Implied Volatility (IV) rank is the most important thing for tastytraders (besides liquidity). So, what is IV rank and how does it help us as traders?
Implied Volatility (IV) refers to how much a stock may move within a year. If a stock is $100 with an IV of 50%, we can expect to see the stock price move up or down $50 over the course of the year. Essentially, the lower the IV is, the less we can expect to see the stock price fluctuate, and vice versa.
At tastytrade, we pay more attention to Implied Volatility Rank (IVR), rather than pure IV (as described above). However, it’s important to note that implied volatility is still very important - we need to look at both IV and IVR when placing a trade. IVR is a metric derived from IV that gives us a sense of how the current IV level compares to IV levels over the past year in the underlying. It is a percentage that ranges from 0 to 100. If volatility rank is low, it is closer to 0, and if it’s high, it’s closer to 100.
As premium sellers, we are always looking for underlyings that have a high Implied Volatility (IV) and a high IVR. This allows us to get further away from the at the money strikes for the same amount of credit, or collect a larger amount of credit if we want to use the same strikes. Also, instead of price direction or duration, we can now profit from a contraction in IV. I have had trades in which I have been directionally wrong, but still made money, because IV contracted from a high number to low.
IVR = (current IV - years low in IV)/ (years high in IV - years low in IV)
So now that we've gone through an explanation on implied volatility, I wanted to highlight 5 studies done by our research team that I found most important for highlighting the importance of high IV in our trading strategy.
This is the basic starting point. Why do we sell high IV rank? In this segment, they talk about how waiting for and scaling into a high IVR, we are able to collect a greater amount of premium, widen our breakevens, and increase our overall probability of success.
As you can see, this study quantifies clearly why we trade high IV: higher win rate differential, higher profit differential per trade, higher average profit per day differential, and higher average credit differential!
In this segment, Tom & Tony first explain why IV and IV Rank are important. They also talk about how just because two underlyings have the same IV Rank, it doesn't mean the premium will be the same for a specific trade. For this reason, it is important to be aware of the IV as well as the IV Rank. IVR tells you where the underlying has been in comparison to the last year’s high and low range, and IV tells you the level of extrinsic value built into the underlying price.
A couple quick takeaways:
- Higher IV widens our breakevens
- Higher IV also increases the credit received (for the same strikes)
When volatility expands in the market, there are multiple short premium strategies that we may implement to capture high Implied Volatility (IV) trade opportunities. This study compares the various high IV strategies to one another.
In the segment they compare the following strategies:
- Iron Fly
The reason I like this study is because they have screenshots of each strategy in dough, which is a great way to learn how each strategy looks and works. This feature is great for beginners like me - I go back to this study whenever I need a refresher on each of these strategies.
I like butterfly spreads as they are a good strategy for beginners, and for people with small accounts like mine. This segment explained how butterfly spreads are great strategies for underlyings with high IVR. A traditional butterfly is a neutral strategy; the belief is that the stock will stay within a range by expiration. We sell two at-the-money, and buy one in-the-money and one out-of-the-money (all calls or puts). The higher the IV, the cheaper the butterfly would be.
Tip: We tend to stay away from selling butterflies at tastytrade, since Tom states they are hard to get out of.
In this study, they look at something really interesting. We know that 45 days to expiration (DTE) is the tastytrade ideal. However, if we have high IV, can we put on a trade with a shorter time period with the assumption that IV will fall faster than when it rises? Check out the study to see the results. I won’t spoil the ending for you.
Although I highlighted five of my favorite segments on IV, there are still so many more studies the research team does every week that teach me something new. Stay tuned to keep up with all of the knowledge!
Are there additional studies around IVR that you find interesting? Let us know in the comments below. And if you enjoy these segments, go to our Market Measures show page for more!
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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Feb 21, 2017
Implied volatility rank (or IV rank for short) is a newer concept in the options trading industry. Any option traders knows what implied volatility is and how it relates to the pricing of options, but few understand what IV rank is. IV rank is a measure that brings relativity to implied volatility.
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