One of the most common metrics used when trading options is the Implied Volatility Percentile.
While it is very frequently used, it is often slightly misunderstood.
This article will explore the metric of IV Percentile.
We will then discuss some of the benefits and drawbacks of using it as an indicator for options trading.
Contents
- What Is IV Percentile?
- How To Use IV Percentile To Trade
- What Am I Missing When I trade IV Percentile?
- The Lookback Period Using IV Percentile
- How To Trade Using IV Percentile
What Is IV Percentile?
IV Percentile is a measure of implied volatility where current implied volatility is compared to the range of implied volatilities in this past.
This comparison is made on the same stock.
For example, Facebook’s IV percentile takes the current implied volatility and compares it to the past implied volatilities Facebook has had.
This is then made into a percentage ranging from 0-100%.
A percentage of zero would depict a stock is currently at the lowest level of implied volatility it has been during the lookback period.
In contrast, an IV percentile of 100% illustrates that the stock is trading at its highest level of implied volatility.
For example, using a one-year IV percentile, if the stock had 51 days trading under the current volatility level, we would divide that number by the total number of trading days in a year (252).
This would give us an IV percentile of (51/252) = 20.2%
How To Use IV Percentile To Trade
Now, of course, the first thing everyone wants to know is simple.
How can I use this to make money?
The good news is that IV percentile is one of the most common metrics used to justify a trade from many, including Tastytrade and Options Alpha.
The thought process behind it is pretty simple.
If the IV percentile is very high, the options are expensive relative to how they normally trade.
One should sell them.
If the IV percentile is very low, the options are cheap relative to normal.
One should buy them.
Before we discuss the limitations of a strategy like this, we cannot argue the intuitive sense.
Buy cheap, sell expensive.
Pursuing a strategy like this is further improved by the fact that implied volatility is mean-reverting.
This means that high implied volatility will normally come down over time, and low implied volatility will normally go up.
The reason for this mean reversion is intuitive.
A stock or the market cannot perpetually trade in a state of fear with 10% swings daily.
Conversely, not everything in the world will always be sunshine, government handouts, and utopia.
What am I Missing When I trade IV Percentile?
There are some major things that traders miss when they trade options exclusively off of IV Percentile.
Here are a few.
1. Realized volatility
When we trade options, we are trading what the market thinks will happen in the future.
The realized volatility is what actually happens; this determines whether our position will make or lose money.
Let’s imagine a security with an IV percentile of 100% and implied volatility of 200%.
It seems like an easy opportunity to sell implied volatility.
What if the stock had 400% implied volatility over the past month?
Imagine we sold a one-month option, and the stock continued to realize 400% volatility.
We would lose a lot of money, even if the IV percentile comes down as we expected.
If there is no time left on the option, it means little if the IV percentile drops back down.
2. Earnings and Announcements
Earnings and announcements are events that often cause significant spikes in implied volatility.
We can easily find stocks with a high IV percentile and low realized volatility.
Though there is a significant event for the company in the future, such as earnings or a possible announcement, the high level of IV may make sense.
***Note: Many investors like to sell options before earnings because of the high IV rank and inevitable IV Crush.
Yet they miss that they are also on the hook for the larger realized moves on their trade earnings.
Lunch is not free here!
Seasonal and Other Effects:
Some assets, especially commodities, tend to have seasonal periods where they can experience high levels of volatility.
Take Natural Gas.
For much of the year, it experiences little volatility but ramps up remarkably going into the fall and winter.
This is as weather, and the risk of storms can cause significant uncertainty on both demand and supply.
In sum, it is important to remember by trading Implied volatility.
We are trading what we think future volatility will be, not simply the implied volatility percentile.
Also, there is no reason if IV percentile is at its highest level, the implied volatility cannot continue to go higher.
While the percentile stays at 100%, there is no limit on how much an investor can lose in these circumstances.
For those who want a recent example, look no further than Gamestop and AMC.
While these seem like freak events, they happen a lot more often than one would expect.
The Lookback Period Using IV Percentile
One of the most overlooked features of IV Percentile is the lookback period.
The lookback period determines what data we are referencing in comparison to our current implied volatility
An example that demonstrates this is as follows:
SPY IV 25% IV percentile 100%
SPY IV 25% IV percentile 10%
Neither of these figures is necessarily incorrect.
One was obtained during a year with very little volatility in 2017, and the other during COVID in 2020.
These differences can be tackled by adjusting the lookback period, which is available on some platforms.
Despite this trying to get the longest lookback window is not necessarily better.
Companies can change drastically over the years.
Having two IV percentiles could be smart (one shorter-term and one longer-term).
Here putting more weight in the shorter-term IV percentile while also having the longer-term one in mind may provide a more comprehensive picture.
How to Trade Using IV Percentile
So simply using IV Percentile as a standalone indicator to buy or sell options can be limiting.
Overall the research is mixed as to whether or not it provides any value as a standalone indicator.
Despite these limitations and drawbacks, trading using IV percentile can be valuable as an indicator used to make a trading decision.
Here are a few examples of how to use IV percentile to trade.
Tesla has an IV percentile of 85%, with low realized volatility.
We do our research and find out that the options we are selling include an event where Tesla will show off its newest model car.
Despite this, we believe the event will not be groundbreaking and that the stock will not move significantly.
We sell an Iron Condor to take advantage of the high volatility.
Proctor and Gamble has an IV percentile of 10%.
The realized volatility is also low.
We think it could be an opportunity to buy some cheap macro volatility.
We find out the company has no earnings or events coming up.
We also see that the S&P has an IV percentile of only 15%. We decided not to take the trade.
Using IV percentile as a tool and other information, we can make more informed trades and develop a more informed thesis.
Do you trade using IV percentile?
If so, how and why do you use it?
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
