The Edge of Implied Volatility Percentile

Implied volatility is one of the most important concepts in options trading. This is the measure most market players use to check if an option is expensive or cheap. In this post we will show how you can use IV percentile (we call it IV rank) to gain an edge in trading.

What is implied volatility

Implied volatility is a “plug number” that when used as input in black-scholes formula, it yields the current option price in the market. The idea is that there are often discrepancies between the theoretical option price according to B&S, and the market price of an option. The implied volatility is used to reconcile these discrepancies and “explain” the market price. We use IV because it is the only ‘unknown’ variable in the B&S formula (Strike, underlying asset, time to expiration  etc., are known).

What is implied volatility percentile? (or rank)

The IV value represents volatility, but doesn’t provide us enough information to know if the volatility is high or low. Without more data, we can’t know if a value of 0.35 , for example, is high or low. We use IV rank to give more information about that fact. A value of 90, for example, means that the current IV is higher than 90% of the past 200 days. Click here to read more about IV Percentile (and how to scan for it). Also – you can check the difference between IV percentile and IV rank.

The IV percentile edge

Implied volatility is cyclical. After high volatility we will see low volatility and vice versa. The key is to know when IV is high and when it is low. For this we will use the IV percentile. In a previous post we showed that the \$VIX tends to go up after low values and down after high values.

We showed this table that shows average \$VIX change after percentile value :

Read the previous post for more details.

This IV behavior also occurs in stocks. Here we will show the results of the backtest we conducted on 5 liquid stocks. The backtest was March 2013-March 2015 for \$AMZN, \$GE, \$MSFT, \$AAPL and \$WMT.

Here are the results:

How to read the tables: For each stock we have the base result – the average IV change for X days over the last 2 years. Then we have the average IV change when IV percentile was greater than value (top rows) and when IV percentile was lower than value (bottom rows).

For example: IV change for AAPL Over 5 days when IV percentile was greater than 90 was -13.9%. This is even more important because the base result is positive:  1.2%.

We can see that this result is consistent across values and across stocks. The higher (or lower) the IV percentile, the more extreme the volatility swing will be to the other side.

Summary

We can see that IV percentile is Cyclical. This means that when IV percentile is high we should look to sell options – and earn from IV drop. Strategies like covered call, naked put, naked calls, credit spreads etc – will have greater chances of success.

When IV percentile is low we should look to buy options. Strategies like long call,  long put, calender spreads etc – will have greater chances of success.

It is important to be aware of the IV in the market and the stock you are trading so as increase your chances of success.