Trying to select the right options strategies, strikes, and expirations? Learn how to rank volatility using IV percentiles and see if changes are normal or unusual.
In this world—they say—change is the only constant. But the magnitude and direction of that change aren’t constant at all. How do you track it? And how do you differentiate “normal” change versus the “not-so-normal” kind?
There’s an old adage among traders: 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 Index (SPX) and the Cboe Volatility Index (VIX) are inversely related. When the SPX is rallying, the VIX tends to be low. And when the SPX is dropping, the VIX tends to be high. So, an ultrahigh VIX might indicate an SPX bottom is near, and an ultralow VIX might indicate market exuberance or complacency.
Like all things Wall Street, it’s far from absolute—just another indicator to keep in your pocket. But what’s high and what’s low? These terms need context. With the weather, we use windsocks, humidistats, and other gizmos. In academia, we use standardized tests and grade point averages. What about when ranking volatility? Many traders turn to the Today’s Options Statistics subtab on the the thinkorswim® platform from TD Ameritrade, and in particular, the Implied Volatility (IV) Percentile and Historical Volatility (HV) Percentile readings.
Perhaps it’s best to start with a quick overview of implied volatility (commonly abbreviated as “IV”). Basically, IV indicates how much a stock could move in the future. Keep in mind that IV always changes because options prices are always changing, depending on how the market anticipates future price moves. For example, IV often rises ahead of expected stock price moves and falls after events such as earnings announcements.
Historical volatility (“historical vol” or “HV”) measures the fluctuation of past prices over a period of time. So, HV tells you how volatile a stock has been in the past. A stock with an HV of 10 is less volatile than a stock with an HV of 35. And it’s possible for a stock to have an HV of 50 during one time period and 15 during another.
But looking at IV and HV doesn’t complete the picture. You’ll need to know how HV and IV rank, relatively speaking. For that, you’ll need to look at IV and HV percentiles. Fire up the thinkorswim platform, pull up a stock, and under the Trade tab, open up Today’s Options Statistics (located below the Option Chain in figure 1).
IV is calculated from the prices of currently listed options and expressed as an annualized level. The IV percentile can range from near zero to near 100%. For example, the stock in figure 1 shows a current IV reading of 33.77%. So, the options market is essentially pricing in about a 34% variability around the current price. But again, that’s an annualized measurement. Other data on the page can help put it in perspective:
So, IV is relatively low in this stock right now. Is it warranted? One way to help you decide is by comparing the IV data to the HV data.
IV is a forward-looking measure implied by the options market, and HV is backward looking. HV is a moving average of actual price variability in the stock over the previous 52 weeks.
How might a trader assess these readings? If you think IV and HV should follow each other up and down, an IV that’s lower than HV could suggest that IV is understating the stock’s potential price change. An IV that’s higher than HV could suggest the opposite. In other words, comparing the two can be a useful way to understand how much expected volatility is being priced in to options versus how much it actually tends to materialize. All else equal, higher IV relative to HV suggests options are expensive, while lower IV suggests options are inexpensive. Keep in mind, however, that past performance does not guarantee future results. IV, after all, is only an estimate.
For the option trader, volatility measures can be important considerations when selecting a trading strategy. For example, a high IV percentile could indicate that options premiums are relatively high, and there might be opportunities to use short options strategies like short vertical spreads. Or you could use covered calls or sell cash-secured puts. A low IV percentile could indicate that options premiums are relatively low, and there might be opportunities to use long options strategies like calendar spreads or long verticals.
Regardless of which products you trade or how often you trade them, options stats can help you track volatility and make more informed trading decisions.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
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