Let’s imagine for a second that you live on the beaches of Florida (or maybe you do already!) If you see the water levels of the beach each day, you can easily tell when the water levels are high or low. A tourist, however, may just come to the beach for the first time and think an extremely high or low water level is normal. You have the ability to put context around the water levels, where the tourist does not. That’s the importance of measuring implied volatility (IV) - putting context around IV levels that we’re seeing. At tastytrade, we focus on two measurements - IV Rank & IV Percentile.
IV Rank is a measurement from 0 to 100 that analyzes the high IV point & the low IV point over a certain time frame, and weighs current IV levels against those points. We usually look at a time frame of one year. For example, if an underlying had an IV low of 50% and an IV high of 150%, an IV rank of 50 would mean IV was currently at 100%. If that same underlying had an IV of 50% or lower, it would have an IV Rank of 0. If it had an IV of 150% or higher, it would have an IV Rank of 100. One of the concerns with IV Rank is that it doesn’t take outlier IV spikes or lulls into account. If an earnings announcement spikes IV to 200% just for one day, the new measurement for IV Rank would be from 50% to 200% for that same underlying. IV Percentile looks to smooth out this flaw and provide a more accurate reading.
IV Percentile weighs each day equally. In the IV Rank example, that earnings spike to 200% has a much heavier weight than the other days of normal IV, because it single handedly moved the range by 50%. IV percentile takes all the trading days for the past year, and measures the percentage of days IV was lower than the current level. This means that even if there was a spike in IV for one day, it wouldn’t change the calculation as drastically. That one data point would then just be excluded from the percentage of days IV was below the current level. This results in a much smoother calculation, but it is harder to calculate off hand than IV Rank.
In any case, putting context around IV is important regardless of whether you use IV Rank or IV Percentile. We suggest picking one that you’re comfortable with and sticking with it, so you’re not looking at two different beaches and trying to compare their water levels similarly!
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