Traders tend to equate high volatility with fear. But volatility can also mean possible trading opportunities. So, instead of avoiding high volatility, learn to use it in your options trading.
Volatility happens. Sometimes it’s big. Sometimes it’s small. In the midst of a global economic meltdown, it gets pretty big. When a pandemic erupts, volatility (vol) can rise to levels most traders have never seen in their lifetimes, just as it did in March 2020, when the Cboe Volatility Index (VIX) hit 85. That’s a level seen only once before in the past 20 years, back in 2008.
But what exactly is vol, and why is everyone talking about it every time the market plunges?
In a word, vol is the movement of a stock or index—or more specifically, the magnitude of its movement. When vol is low, there may not be much movement from one day to the next. Price moves are relatively small and orderly relative to the stock’s price. On the flip side, when vol is high, there’s a lot of movement, and the size of price moves can be quick, fierce, and wildly unpredictable. Investors usually don’t love it when the market is unpredictable. So, when there’s too much vol, they might run for the hills.
But for a trader, vol can mean potential opportunity. That’s because traders typically look for short-term price fluctuations and aren’t married to a particular direction. They’re focused on what they’re trading at the moment. They trade what the market gives them. And if you’re an option “volatility” trader, a world of possibilities opens up.
It doesn’t help that vol is used in different ways. Headlines may exclaim, “The market is volatile!” Traders talk about “implied volatility” and “historical volatility.”
When talking about options, vol simply means implied volatility, or IV. It’s derived from options prices, and it “implies” what a stock might do in the future. You can enter prevailing options prices into a theoretical pricing model, which will spit out the IV. Or, enter an IV to get your options prices. When you freeze all other inputs in the pricing model—interest rates, time to expiration, strike prices, etc.—options prices and IV are different sides of the same coin, and one can be translated into the other.
Either way, stock options prices and IV can often give you an idea of the expected movement range of the underlying stock—helpful info for setting up trades.
Keep in mind that when IV increases, it’s an indication the market expects the stock price to move more than it did before. When IV falls, it’s an indication of potentially less price movement.
Instead of trying to keep track of the IVs for every stock, wouldn’t it be great if there was one IV number that covers everything?
This is where the VIX comes in. The VIX measures the IV from a mix of S&P 500 Index options that have expirations close to 30 days. Although it doesn’t reflect every stock and exchange-traded fund, it’s a pretty good indication of overall market vol at any given moment.
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Despite what you may hear, vol and VIX don’t trend like stocks. Rather, they’re “mean-reverting,” which means they tend to hang out at certain average levels and trade in particular “regimes,” or ranges, around these levels. Although vol can move in and out of these regimes, it typically reverts to those average levels sooner or later. Of course, there are always exceptions. The idea is to understand when a new regime is in place. Spikes in volatility are typically temporary, because they tend to revert back to the mean, historically speaking.
Take VIX, for instance. Before the pandemic in the first two months of 2020, the VIX typically traded, on average, below 15. Sometimes, it would slump to 10; other times, it would spike to 30 or 40. But then it would generally go back to its “typical” range.
But that was pre-pandemic. As fears of a slowing global economy grew, so did vol. The higher IV moves beyond a normal range of between 12 and 20, and the longer it stays there, the longer it may take for it to return to anything closely resembling a previous norm.
Now that you have a better understanding of vol, how do you make sense of it?
Volatility charts. First, determine whether the current IV is high or low, because that might help when choosing which options strategy to use. One way to compare vol levels is to add the ImpVolatility study to your charts on the thinkorswim® platform from TD Ameritrade.
Today’s options statistics. This is found under the Analyze or Trade tab, below the Option Chain. Note the prevailing IV level and compare it the high and low IV levels over the past 52 weeks.
FIGURE 1: WHERE IS IV? Compare IV with its 52-week high and low in Today’s Options Statistics, found below the Option Chain in the Analyze tab on thinkorswim. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
In figure 1, the highest level IV reached over the previous year was 82.3%. The lowest level was 11.2%. Prevailing IV is at 32.07%, which puts it in the 29th percentile. That means it’s a little closer to the lower midrange than the high end. Yet, it’s still much higher than what used to be considered the “normal range” of 12% to 20%, and there’s still room to move. This doesn’t typically bode well if you’re buying options because vol premiums will be higher. You could potentially offset some of that vol risk by buying in-the-money (ITM) options, vertical spreads, or straight stock.
If IV were closer to the top end of the range, you might view it as “high.” Then you may consider strategies that have short vega profiles (geek-speak for strategies that should profit if vol drops) like short iron condors, short verticals, and long butterflies. Yet, even if vol is at the high end of the range, it doesn’t mean it can’t go higher.
Probability cone. Use this tool to help position your strikes. Select the Analyze tab > Probability Analysis, and you’ll see a chart that looks like a bell curve on its side. The probability cone helps you visualize vol because it maps the expected range of the stock based on the current IV level and number of days until expiration for each option.
In figure 2, the current stock price is around $180. Yet, over the next 30 days, the probability cone pegs the expected range (based on current IV) from $162.44 to $198.60 with a 68% probability (the expected price move is one standard deviation). The actual range could be greater or smaller, and you could use this information to consider selling vertical spreads with the short strike just outside the range with a theoretical success probability of 68%. Or, you could use this tool to tweak other options strategies by changing strike prices or expirations to see how your break-even levels might compare with the expected stock price range.
FIGURE 2: PROBABILITY ANALYSIS. This tool shows the expected price range, based on the current stock price and implied volatility, at various expirations. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Market makers. Another tool to help figure out expected movement is the Market Maker Move (MMM) indicator.
It’s based on formulas used by market makers to calculate how much a stock is expected to move in a single day. In figure 3, for example, the MMM is $2.30, and yes, this number is based on prevailing IV. It doesn’t always show up for every stock, but it’s usually triggered when an event is near, such as earnings. All things being equal, this number gets bigger when IV goes up and shrinks when IV goes down.
FIGURE 3: MARKET MAKER MOVE. The MMM calculation gives you the expected one-day range of the stock. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Bear in mind, however, that the actual range can be larger or smaller, and it also doesn’t suggest the stock direction. But this number can be helpful in many ways, such as when you’re deciding to make adjustments to existing trades going into an earnings event. Likewise, if the daily moves keep exceeding the MMM, it might be an indication that IV is on the rise.
These are just a few tools the thinkorswim platform to help a vol trader analyze IV. Armed with all this information, you’re on your way to learning how to trade vol—or at least becoming someone who doesn’t need to fear it.
Trying to figure out why a stock’s IV is high or low is an important factor, but so is trying to determine the strategy to apply based on prevailing volatility levels. This table can be a handy reference.
Kevin Lund is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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