Implied volatility (or IV as the kids call it): we cannot get enough. Or can we? For each underlying asset there are multiple IVs listed. There is an implied volatility for each option strike price. There is an IV for each weekly series. Then there is the monthly IV (or what we sometimes call “underlying IV”). Finally, there are the IV rank / IV percentile. If we want to calculate the expected move, which one do we use? Further, when IV is low, is it still dependable when calculating expected moves?
So Many Choices
When we want to calculate expected moves, the choice as to which IV we should use can be overwhelming. Deciding which IV to use is your choice. But here are some tastytrade guidelines we use for calculating expected moves:
- Individual Strike IV - almost never
- Underlying IV - monthly approximation
- Option Chain IV (i.e., weekly series) - most precise, especially around upcoming binary events such as earnings
- IV Rank / IV Percentile - helps pick a strategy
Different measures of IV can fluctuate dramatically. We often see this during earnings season. That is why we default to the weekly option chain IV for earnings trades. Outside of earnings season; however, we most often use the underlying IV.
Low IV Reliability
In a recent episode of Market Measures, we discussed expected moves versus actual moves. We know 68% of the time price stays within its expected move. In the S&P, that number is much higher at nearly 83.5% using a 45 day window. In other words, more often than not, actual price moves fall within the expected range.
We do not need to remind anyone about the generally low IV environment plaguing markets the past few years. Therefore, we studied how often actual moves in SPX, NDX and RUT fall within expected ranges during periods of low volatility. We examined what happened when IVR was below 25% and when IVR was between 25% and 50% since 2005.
Our research uncovered that even in periods of low volatility, expected moves overstate actual moves. In the S&P, with an IVR below 25%, actual remained within the expected move range 80% of the time. For the Nasdaq and Russell, actual moves stayed within expected moves 70% and 79% of the time, respectively.
If we bump the IVR up to somewhere between 25% and 50%, it should come as no surprise actual moves remain inside expected moves even more frequently. For the S&P it becomes 91%. In the Nasdaq, 84% and the Russell, 87%.
IV is our friend. Whether it’s high or low, it frequently creates a mirage around value causing option prices to be overpriced. If we properly identify which is the best IV to use, even in times of low volatility, data supports selling premium as the best and most consistent way to trade.
Josh Fabian has been trading futures and derivatives for more than 25 years.
For more on this topic see: