Varied Uses of Implied Volatility
Jun 28, 2017
In options trading, one of the most important data points available to market participants is implied volatility (IV).
Implied volatility is the current market price for volatility - much like the sticker price you'd see on a retail product.
Due to the efficiency of the options market, implied volatility is dynamic and reflects ongoing supply and demand. In this regard, it is constantly providing traders with important market information.
As discussed on a recent episode of Options Jive, traders can use the current level of implied volatility in several important ways, including:
Differentiating expensive and cheap
Adjusting notional values for IV
Because options are priced based on expected movement in a stock, the "implied" part of "implied volatility" has real-world application. The slide below, from the aforementioned episode of Options Jive, illustrates how implied volatility can be used to calculate expected move:
As you can see, calculating the expected move using the equation pictured above can be extremely useful for traders as they sanity check potential positions.
Naturally, this leads us to the question, “Is implied volatility priced fairly?” - which brings us to the next important use for implied volatility. Just like that one popular Christmas present invariably gets bid up to insane prices very year, the price of volatility also experiences significant fluctuations in value.
However, in the case of implied volatility, it's easy to see how much a stock has fluctuated over time. Therefore, it's also relatively easy to see how expensive or cheap implied volatility is compared to past movement.
At tastytrade, we use an in-house measurement known as Implied Volatility Rank (IVR) to differentiate whether implied volatility is cheap or expensive. IVR uses the past year of implied volatility data in a specific underlying and reports whether current implied volatility is on the low, fair, or high end of that historical range.
So if stock XYZ had an implied volatility range of 30 to 60 over the past year, and implied volatility is currently trading 45, then the IVR rank for XYZ would be 50%. At tastytrade, we look for opportunities to sell volatility when IVR is above 50%, and look for opportunities to buy implied volatility when IVR is below 50%.
As outlined on Options Jive, the IVR ranking can also help us select specific strategies that match current market conditions.
For the best understanding of this material, we encourage you to watch the complete episode of Options Jive focusing on implied volatility when your schedule allows.
On the show, the hosts also explain the concept of “implied volatility notional value.” You may find this discussion extremely helpful for setting up future trades. IV notional value can help provide perspective on underylings with different stock prices and implied volatilities for comparison purposes.
If you have any questions or comments on implied volatility we hope you’ll reach out at firstname.lastname@example.org at your convenience!
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.
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