Volatility trading: when to buy and when to sell volatility
You got to know when to hold ’em,
Know when to fold ’em,
Know when to walk away,
And know when to run.
When to sell implied volatility
Volatility is a nicely reverting time series. If it is high chances are good that it will come down again. The only problem is to find out when volatility is high, and when it is low. Unfortunately there are no absolute levels, you can’t say that 50% implied volatility is high, as this specific stock might have an implied volatility of 80% most of the time. So you can only compare the current volatility level to historic levels and so define if volatility is currently high or low.
One simple measure to find out if volatility is high or low would be the volatility rank. It is calculated like the stochastic indicator used in technical analysis. Volatility rank (in %) = (current IV – Min IV)/(Max IV -Min IV). The maximum and minimum of volatility is usually calculated over one year.
But this calculation method has got some major drawdowns. Singular implied volatility spikes will affect the values of the year after, and it will seem that volatility is low, just because it is low relative to this one spike, but not in a broader sense. Also the absolute level has not meaning by itself. 50% would just mean that current IV is 50% of the last spike up.
IV Percentile – a probability based indicator
Unless IV rank, the stochastic like indicator, IV percentile is a probabilistic indicator. It does not give the position of current implied volatility relative to it’s historic levels, it give the probability of IV for being lower than today. So a IV percentile reading of 0 (zero) means, that there has been no IV lower than the current one. This would be a nice setup for buying volatility. It most probably will go up. On the other side, a volatility reading of 93% (as we have it on October 12th after the S&P sell-off means, that on 93% of all days in history volatility has been lower than the current one. You might want to go with the probabilities and sell volatility.
IV percentile does not only give you a level, it also gives you the probability of falling volatility.As soon as IV percentile is above 50 you have a better than 50% chance that volatility will be lower soon. Have a look at the VIX article I did, it comes to a similar conclusion. This is a key indicator when you plan to sell implied volatility.
Scan for IV Percentile
IV percentile is the perfect indicator for a market scan. Find all stocks with an IV percentile above 50 (look for 85% and higher…) and you will have an edge when selling volatility. As you can see on the chart above, a high IV percentile number also correlates with an implied volatility being above the fair bet volatility. So your edge actually has two legs: (1) current IF is high and will most probably revert down (IV percentile > 50%) and (2) implied volatility is overpriced according to historic measures.
If you add all the edges you can get the luck will be on your side.
Free IV percentile data is available at https://www.optionstrategist.com/calculators/free-volatility-data
The analysis has been done using the tradesignal software suite.