1. Setting the Stage: The Role of Volatility in Options Trading
Before we dive into the intricacies of implied volatility and its siblings, let’s understand volatility’s role.
In options trading, volatility isn’t just a measure of how much a stock might move. It’s a critical component that dictates option pricing. A higher volatility often means higher option premiums, and vice versa.
2. The Cornerstone: Implied Volatility (IV)
What is Implied Volatility?
Implied Volatility (IV) is a metric that captures the market’s expectation of how much a stock is likely to move in the future. It’s derived from an option’s current price. If the market expects significant stock movement, IV (and thereby, the option’s price) will rise.
Imagine two companies: StableTech and WildRideTech.
StableTech has had steady growth and minimal price fluctuations. WildRideTech, on the other hand, has seen wild price swings due to unpredictable news events.
The options market will perceive WildRideTech as having higher implied volatility compared to StableTech. Consequently, options for WildRideTech will be more expensive.
3. Understanding IV in Context: IV Rank & IV Percentile
IV Rank=52-week high IV−52-week low IV/current IV−52-week low IV
IV Percentile tells us the percentage of days in the past year that the IV was below its current level. So, if the IV Percentile is 70%, it means the current IV is higher than 70% of its daily values in the past year.
Let’s go back to WildRideTech.
Suppose its current IV is 50%. If over the past year, its IV fluctuated between 20% and 80%, and the current IV was higher than its past values 60% of the time, then the IV Rank is 50% and the IV Percentile is 60%.
4. Leveraging IV for Trading Strategies
Sell Options in High IV:
When IV Rank or IV Percentile is high, it might be an opportune time to sell options. High IV generally means that option premiums are inflated. For example, selling covered calls or putting on credit spreads might benefit from a decrease in IV (volatility crush).
Buy Options in Low IV:
Conversely, when IV Rank or IV Percentile is low, it might be advantageous to buy options. If you anticipate a spike in IV or a large price movement, strategies like long straddles or strangles might be suitable.
Stay Neutral with Iron Condors:
If you believe IV will remain stable, iron condors (a combination of selling and buying both calls and puts) can profit from the stability in IV, earning premiums without expecting a large price swing.
While IV offers a snapshot of the market’s sentiment about a stock’s potential movement, IV Rank and IV Percentile provide context, helping traders understand if the current IV is high or low historically.
By understanding these concepts, options traders can better assess market conditions and tailor their strategies accordingly.