The volatility Rule of 16 can be useful when figuring out how much an options price is likely to move especially during earnings. This can be helpful in planning trading entry and exit points.
For traders, the markets and the Cboe Volatility Index (VIX) are like peanut butter and jelly—forever interlinked. Although it’s viewed as a “fear gauge” by TV talking heads, VIX can also tell you a lot about how big the next move might be. But there’s an interesting aspect of VIX that has to do with the number 16 (approximately the square root of the number of trading days in a year). Without getting too geeky about the math, there are two things you should know:
That’s the essence of the “rule of 16.” Once you get it, you can do all sorts of tricks with it.
If the VIX is trading at 16, then one-third of the time, the market expects the S&P 500 Index (SPX) to trade up or down by more than 1% (because 16/16=1). A VIX at 32 suggests a move of more than 2% a third of the time, and so on.
FIGURE 1: RANGE CHANGE. In March 2020, the VIX spike wasn’t just about a falling market; intraday ranges also intensified. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Is a certain level in VIX justified? Check the table. For example, during the coronavirus selloff in March 2020, a rise in VIX above 50 was accompanied by a trading range in excess of 4% for nine straight sessions—a few of them up or down by more than 8%. The rule of 16 puts such a volatility (vol) spike into perspective.
The rule of 16 works the other way, too—for VIX and any stock or index option. You can “annualize” a daily reading by multiplying it by 16. Say a stock had a few moves in excess of 2%, and you think such a daily move might be typical in the near future. If so, you could expect an annualized vol of 32%. If you compare your expectation to the current IV, it might indicate whether an option is overpriced, underpriced, or fairly priced.
General measurements of vol such as VIX and the rule of 16 don’t necessarily tell the entire story. Instead, consider them in the context of the bigger picture. Is a company or one of its competitors about to report earnings, declare a dividend, or take another corporate action?
From a numbers standpoint, the rule of 16 can help you plan your entry/exit points, and if you trade options, it can help you with strike selection.
But remember: VIX just tells you the odds of something happening. It’s not a sure thing. At least these tricks can give you some perspective to help make sense of the numbers.
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