There are two ways we measure volatility: Implied Volatility (IV), which is per strike, and the Vol Index, the VIX-style overall volatility. Both are derived from current option prices. They tell us what the market expects for the underlying. Is one better than the other?
The Vol Index is a weighted average of out-of-the-money (OTM) option prices. Implied Volatility is a Newton-Raphson iterative calculation based on the current option price, its Vega, and an option pricing model (we use Black Scholes). What that means is that to find IV we perform a repeating series of calculations to find IV. It usually takes at most five iterations to find a theoretical value for IV that produces a price close enough to the market. TP explained that it was only with increased power and speed from computers that such calculations were possible. Speeds are advanced enough now that it can be done from a central server and the quotes distributed in real time. TP went through the calculations.
As a benchmark, we often sell options that have an 84% probability of expiring worthless. When volatility is lower the 84% OTM strike (aka the 16 Delta strike) is closer to at-the-money (ATM). Higher volatility means the strike is further from ATM. Each method, IV or Vol index, will produce a different number. The difference is because of Volatility Skew which makes the OTM Put higher and the OTM Call lower than the Vol. The greater the discrepancy between IV and Vol Index, the greater difference in the 84% strikes. It results in a 2% difference with the Puts being further OTM and the Calls being less OTM. The practical results, based upon 5 years of data, is that the 84% OTM Put using IV expired OTM 96% of the time but 92% of the time for Vol Index while the corresponding Call expired OTM 87% and 90% of the time respectively.
We use IV to calculate the greeks and probabilities for each strike, and for primary trade selection. Vol Index is useful for research and portfolio analysis.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastytrade is a trademark/servicemark owned by tastytrade.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”).
tastyworks, Inc. (“tastyworks”) has entered into a Marketing Agreement with tastytrade (“Marketing Agent”) whereby tastyworks pays compensation to Marketing Agent to recommend tastyworks’ brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of Marketing Agent by tastyworks. tastytrade is the parent company of tastyworks. tastyworks and Marketing Agent are separate entities with their own products and services. tastytrade has different privacy policies than tastyworks.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.