This fall Madison Avenue will tell us that some color—red? blue? yellow?—is the new black. And whatever you wear in that color, the experts promise, you’ll look younger, or thinner, or get invited to more A-list parties. In reality, you’ll likely be home on Friday night as usual, but it’s still a signal there’s been a fashion change.
In the trading world, we also have signals. They say that when the VIX is high, it’s time to buy. When the VIX is low, it’s time to go. The idea is that the S&P 500 and the CBOE Volatility Index (VIX) are inversely related: When the S&P 500 is rallying, the VIX tends to be low. And when the S&P 500 is dropping, the VIX tends to be high. So, high VIX may be a time to buy the S&P 500. Low VIX may mean a time to short the S&P 500.
Like all things Wall Street, this isn’t absolute, but it’s another indicator to keep in your pocket. So without Madison Avenue to clue us in, how can we tell if the VIX has switched colors?
Where's Vol Now?
The IV percentile is a metric in the thinkorswim® trading platform that compares the current implied volatility (IV) to its 52-week high and low values. Those range from near-zero, when the current IV is at its 52-week low, to near 100%, when the current IV is at its 52-week high. See Figure 1, below.
The larger the IV percentile, the higher the current IV relative to past values. The IV used for the percentile is the volatility index for the stock, index, or ETF you're eyeing. That’s the CBOE’s VIX-style calculation based on the symbol’s options. So, it’s an overall implied vol number.
A near 100% IV percentile doesn’t mean that the current IV can’t go higher, nor does a near-zero percent IV percentile mean the current IV can’t go lower. But if you believe that implied vol is mean reverting, you may predict that the higher the IV percentile, the more likely IV is to drop. And the lower the IV percentile, the more likely IV is to rise.
A value is “mean reverting” if it oscillates around some average value. For volatility, mean reversion describes when IV goes up, then comes back down to an average. When it goes down, it comes back up to an average—and so on. But IV is only an estimate.
Take the VIX. It might oscillate up and down around 16% like it did for much of 2015. Then when uncertainty builds in the market, the VIX moves higher. And it might stay higher, oscillating around a new, higher mean—as it did when it hit 20% in the early weeks of 2016. Here’s the catch: there’s no way to know when IV is starting to revert to a higher or lower mean. In other words, IV is mean reverting... until it isn’t.
With that in mind, examine the IV percentile to determine which options strategy to apply. Remember, all things being equal, the higher an option’s implied vol, the higher its extrinsic value. A high IV percentile could indicate that option premiums are relatively high, and there might be opportunities to use short option strategies like short vertical spreads. A low IV percentile could indicate that option premiums are relatively low, and there might be opportunities to use long option strategies like calendar spreads or long verticals.