Traders are betting more and more that the stock market will soon snap out of its prolonged slumber.
This can be seen through a measure called skew, which looks at bullish CBOE Volatility Index, or VIX, options contracts compared with bearish ones. It’s at its highest level in two years, ha risen swiftly in recent weeks, indicating an expected volatility spike.
What sometimes gets lost in the broad discussion of VIX and general market volatility levels is the specifics of how implied volatility gets factored into individual option prices impacting position profitability.
Implied volatility is one of the most important concepts when trading options. In this article, we’ll try to understand a little bit more why it is important and how to use it when trading to increase our profits. With earnings season beginning in earnest next week this is a good time to review some basic concepts surrounding volatility, both real and implied.
IV is the Answer
What do former NBA star Allen Iverson and implied volatility have in common?
They have both been labeled “The Answer.” While Iverson has been more of a question lately (on what did he spend that $100 million+?), implied volatility remains the key to answering the number-one question on an option trader’s mind:
Is this option “cheap” or “expensive”?
Implied volatility is a ‘plug number’ (a placeholder number used to make the calculation estimate correct), used to get the result from the commonly-used apparatus for valuing options, the Black-Scholes model.
The model considers 5 factors in calculating a particular option’s theoretical fair value:
- The price of the underlying security
- The strike price
- The time, or expiration date of the option
- Interest rates
- Implied volatility
The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us “theoretical” implied volatility, which helps us decide whether an option is cheap or expensive.
But given that options trade regularly, there is already an “actual” implied volatility assigned to each option based on its price, which is constantly updating in real-time. Therefore, our mission, should we choose to accept it, is to determine whether an option’s current price looks cheap or expensive based on its volatility level.
High or Low? Depends?
IV has major impact on trading, and to simplify this idea, let’s look at an example:
Stock A is priced at $100 and has high implied volatility. Let’s say the call strike 100 costs $4.
Stock B is also priced at $100 but has low implied volatility. Let’s say the call strike 100 costs $1.
When comparing the two trades, we can see that the break even point of stock A is $104 and for stock B is $101. This means we have an increase of 1% to show profit in stock B, but 4% in stock A. Furthermore, if we assume a similar increase, let’s say 5% in each stock (by expiration) – we can see we will have $1 profit in stock A but a $4 profit in stock B. The following Table summarizes the two scenarios:
Compare high and low implied volatility scenarios.
To put it simply: When IV is low it’s easier to profit and your profits are higher (for buyers) and when IV is high it is harder to profit and the profit is lower. Of course, it is vice-versa for option sellers.
Sometimes, however, higher IV is justified – mainly due to stock volatility/conditions or market conditions. For example: NFLX volatility is twice as high (in percentage) compared to WMT. We can expect the IV and the options premium to reflect that as well.
An analogy could be done to the PE ratio – most of the time a company deserves a high or low PE ratio. But when it’s extreme it usually is a contrarian sign.
So, how do we know if IV is high or low? and more importantly – How do we know if the odds are in our favor? We can use IV Percentile (Rank)
IV Rank (percentile) is a measurement of stock IV. For example: If a stock has IV Rank of 92.5%. This means that over the last 200 days 92.5% of the days had lower IV than the current one. Or to put it simply: The current IV is high.
These calculations have several characteristics:
- It is fluctuating between 0-100
- It is mean reverting (after a high value you can expect a lower value in higher probability)
- If the IV rank is high – it is more favorable towards options selling.
- If the IV rank is low – it is more favorable towards options buying.
Right now we are in an interesting place; volatility, both real and implied, are at the low end of their historical range. This is despite the relatively high level of overall uncertainty.
With earnings coming up I expect both realized and implied volatility levels to increase. Knowing how this will impact your impact your positions will help them become more profitable.
— Steve Smith