The magic of implied volatility

VIX and implied volatility in general is a measure of the expected market move. If VIX is trading at 50, the option market expects that the market will stay within 50% up or down within the next year.

Implied volatility is not set by any mathematical formula or sophisticated calculation, it derives from the prices paid for put and call options. In dull times and bullish markets people are not willing to pay a lot for portfolio insurance, that’s why implied volatility is low. If there is a crash, high prices are paid for an insurance, which results in a high implied volatility.

Options are a two sided and fair market. You can be the buyer or the seller of an option. This guarantees an efficient pricing for the expected move.

Implied Volatility for one year in %

The chart above gives the implied volatility for SPY options. It is based on 30, 60, 90 days to expiry option series and shows the expected annualised % move.

As it turns out, this volatility prognosis has been quite accurate.

Inside Volatility projection – ATM IV > 10%, 30 days to expiry

If you would have placed a bet that the market is within the given ATM implied move (short straddle), you would have been right 74% of the time. That’s even better than what you would expect for a one standard deviation move. (theortically 68% vs. 74% practically) Usually implied volatility tends to be overpriced.

When markets start to pick up volatility, and that’s usually when it is going down and people get nervous, this prediction gets even better. Due to panic people are paying more for insurance than needed.

Inside Volatility projection – IV above 20%

Inside Volatility projection – IV above 30%

Inside Volatility projection – IV above 40%

Inside Volatility projection – IV above 50%

 

As an options seller you have to act counter intuitive. Placing a bet that the market will stay within a given range of one standard deviation does not work best when markets are dull (IV<20%). This bet has got the highest probability of success when everyone is panicking and the markets are moving fast!

The downside is, that these high volatility times do not occur too often. While the market priced in a yearly volatility above 20% on 669 days over the last 3000 days, it only had a volatility of above 50% on 43 days within the last 3000 trading days.

To get a better idea on how this looks in reality have a look at the sample trade below. (Paypal straddle)

Paypal – somewhere in the green area for profit

Paypal strangle in times of volatility spikes: 30% up or down…

 

Stay careful, a lot of traders have died from statistics. A 100% hit rate, as shown with the statistics above, does not mean that it is actually a good idea to set up a straddle right now.(*) Surely you should not do a leveraged trade.

But if you are invested in stocks right now, closing the stock position and switch to a straddle seems to be a good idea to me. You keep the chance of making short term wins. And if things go south, your P/L will be better than that of a long trade in stocks.

Example above: If Paypal stays within 80 and 125 until expiry you keep the 1.07k. If Paypal falls to 40, you keep the 1.07k, but also lose 100*(today(~102)-40). So you would lose with your straddle, but outperform a direct investment in 100 Paypal stocks by 1.07k$

Thanks to TradeSignal for the software to run these tests, thanks to Refinitiv for the implied volatility data. Thanks to Tastyworks for the trading platform

 

 

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