How to gauge where volatility stands?
Volatility Ranking is an essential piece of information for options traders. Volatility is a major driver in pricing options, and we now know that it is also a bit of a ‘chicken and egg” situation as Black & Scholes is a closed equation i.e. we need IV to determine a price and we need a price to determine IV !
On can easily notice in the above chart that IV, except for the end of Aug ’15 correction i.e. volatility spike, is historically largely range bound (13% – 24%). In this instance (RUT), one can also use RVX (see below) as a proxy for volatility. RVX is a volatility index based on multiple strikes hence different figures yet an overall similar shape.
What shall we use in order to detect market opportunities ?
The first chart provides useful information with regard to how IV is positioned versus HV (historical volatility). HV is not forward-looking per se, yet like any time series, it can be used for short term projections. IV on the other hand is an instant calculation of actual real-time volatility. Hence conventional wisdom assumes that options tend to be overpriced when IV > HV. More generally, most of OM strategies are Vega-negative so are likely to fare better when IV is high and going down. What is “high” though? This is where IV Ranking comes into play.
IV Ranking or Volatility Ranking is simply placing a stochastic oscillator on IV historical data to gauge where it stands in relation to highs and lows.
What shall we use for a sample ? one year ? Shall we take the full sample ? Well, that decision remains at the user’s discretion. One would however be tempted to use a minimum of 6 months for a monthly strategy, and we may want to remove outliers that skew the skew !
For that reason, IV Percentile may alleviate the distortion a little. IV Percentile should ring a bell to anyone who has done a little bit of stats at school.
IV Percentile will therefore downplay the influence of the volatility spike.
Of course, net selling income traders would prefer IV to stand in the higher 1/3 of historical rang, whatever metrics is used. That said, considering possible outliers, it remains important to calculate whether the usual strategy brings a similar premium as previous months. There is no better to check the risk attached to the next planned entry.
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