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Options JiveMean Reversion of Volatility | May 6, 2016
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    Options JiveMean Reversion of VolatilityMay 6, 2016

    We believe in selling option premium when implied volatility (IV) and implied volatility rank (IVR) are high. One important reason why is that while prices aren't necessarily mean-reverting, volatility will experience mean-reversion. What does that mean? How does the reversion work? What would happen if this phenomenon did not exist?

    Implied Volatility is derived option prices and measures perceived future risk. Historical Volatility is derived from past observations and is about the past. An 11-year graph of the daily returns of the S&P 500 was displayed. The graph highlighted the 2008 crash. This period of high volatility provided big up and down daily returns creating a wide band during that period. It showed volatility reverting to the mean.

    A ten year graph of the VIX along with a simulated graph of the VIX if volatility was not mean reverting was displayed. The graph showed that if volatility was not mean reverting it would act like a stock made up of a succession of random steps. Since this isn’t what happens we choose underlyings with high IV Rank or high IV Percentile because IV should revert to the mean and contract. That contraction decreases the range of returns and the option prices.

    For more information on Mean Reversion see:

    Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and to better understand the mean reversion of volatility and its significance for our trading.

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