Implied Volatility (IV)
Implied volatility is a measure of the degree of price fluctuations that investors expect in a given stock or other financial asset in the future.
What Is Implied Volatility?
Implied volatility is a statistical measure of the expected amount of price movements in a given stock or other financial asset over a set future time frame. Traders use IV for several reasons which can include:
- As a measurement of risk for a given trading instrument.
- To calibrate models such as value at risk (VAR) and to establish position sizing and limits.
- To calculate fair prices for options contracts using models such as the Black–Scholes method.
- To tell whether an asset is currently at a high or low level of volatility compared to its history.
- Determining if the market as a whole is currently at a high or low level of sentiment.
IV is an interesting concept in that it's directly used for things such as helping set the price of options and determine appropriate risk sizing for portfolios. But it also serves as a more general sentiment gauge on where a stock or index is as a whole. High volatility tends to signal rapidly-changing market conditions and is sometimes associated with sharp declines in the value of the given stock or financial asset being tracked.
The VIX Volatility Index serves a specific measure of implied volatility for the S&P 500 over a 30 day span. Many traders and market pundits look to the VIX for a quick measure of whether the market is calm or nervous.
The VIX is just one way to track volatility in the S&P 500, however. IV, more broadly, is calculated for a massive number of options on stocks, exchange-traded funds, currencies, commodities, and so on. And knowing how it works can help investors manage risk and trade options more profitably.
How Is Implied Volatility Calculated?
Implied volatility is calculated through working out calculations for the various data points that are generally fed into an options pricing model such as Black-Scholes. Black-Scholes is a famous model that was popularized in 1973 for determining pricing of options and other corporate liabilities. Its success was instrumental in driving the growth of the options exchanges and eventually led to its inventors earning the Nobel Prize in Economic Sciences in 1997.
A typical model for pricing options might include the following data points:
- Price of the option in question
- Price of the underlying stock or financial asset in question
- Strike price of the option
- Time until the option expires
- The risk-free rate of return (such as the interest rate of treasury bills)
- Dividend yield (if the stock or index in question pays dividends)
Plugging all of this data into the model and then calculating through it would spit out a given implied volatility for the option in question. As it's a complete formula, other data points can be solved for as well. Start with a given implied volatility, for example, and the trader can change things such as the time to expiry to see how much pricing would change.
How To Read Implied Volatility for Options
Given the complexity in calculating implied volatility and options pricing, many traders tend to rely on Excel formulas, calculators, or brokerage software to run the numbers. That said, there is a handy tip to help understand IV readings at a glance. It's called the Rule of 16. The Rule of 16 can help traders turn complicated IV statistics into useful trading information.
Volatility is based on standard deviations, and is generally expressed in annualized terms. However, annualized volatility is hard to understand in the context of short-term options, such as those expiring in a month. However, annualized volatility can be converted into a shorter-term tool.
The typical trading year has roughly 252 days in it. The square root of 252 is 15.87, or 16 when rounded. When the annualized volatility is 16, the market is pricing a one standard deviation move in a given stock to be a 1% trading range per day. This would mean that on
- 68% of trading days, the stock should move up or down less than 1%
- 95% of days, it should have a less than 2 standard deviation (and thus 2%) range
- 99.7% of trading days, it should move less than 3%
This can serve as a useful reality check for a given option. If a stock is quoted at an IV of 16, ask whether it is regularly having big swings well outside of the parameters described above. If that's the case, the IV and thus associated options may be mispriced and may represent an opportunity for a profitable trade.
But what about options with an IV other than 16? In that case, the expected trading range moves in multiples of 16. For example,
- An IV of 24 would imply an expected daily trade range of 1.5% to be a one-standard deviation move.
- An IV of 32 would imply an expected daily trading range of 2%.
- An IV of 48 would imply an expected daily trade range of 3%.
What Is a High IV Index vs. Low IV Index?
There's an important distinction when addressing this concept. Each stock or asset has a range of IV that it tends to move between. These levels are determined by the given volatility of that particular instrument.
For example, in something like a major currency, IV tends to be very low. It's common to see one-month implied volatility figures for currencies such as the Euro in the single digits. Stock market indexes tend to have relatively higher volatility; the S&P 500, as measured by the VIX, is often in the 15-20 range.
Individual stocks tend to have higher volatilities than their corresponding indexes. That's because of what's known as single-stock risk. Any particular company can have a key employee leave, an accounting scandal hit, a takeover be announced or any other such sudden development which can cause a drastic short-term change in the price of said stock. Meanwhile, in a diversified index like the S&P 500, these individual risks are mitigated through having many securities in the underlying basket of holdings.
Within individual stocks, IVs are also distinct. A speculative biotech company, for example, could easily have an IV north of 100 when heading toward a key clinical trial readout. Meanwhile, a sleepy utility or packaged food company is likely to have a far lower IV reading. An IV figure by itself often lacks context. As such, many investors use related measures such as IV percentages to understand where a given instrument's IV is compared to its historical range.
IV Rank & IV Percentile
Options traders often look at IV rank and IV percentiles, which are relative measures based on the underlying implied volatility of a financial asset.
- IV rank is where a stock's IV is within its 52-week range. Say a stock has had an IV that fluctuated between 20 and 40 and it's now at 36, it would have an IV rank of 80, since it is at 80% of the distance between its 52-week low and high.
- IV percentile is the number of days over the past year where a stock had a lower IV than it has on the current trading day. This is calculated by dividing the number of days with an IV under the current one by the number of days in a given trading year.
IV percentile is useful for determining if volatility tends to be higher or lower than where it is today, whereas IV rank gives a sense of where a given IV figure is within its broad trading range.
Benefits & Pitfalls of Using IV Percentages
Pros
- IV tends to be a mean-reverting instrument: Volatility heads back to its average after a time, creating opportunities to profit from extreme readings.
- IVs vary greatly between assets: The IV of an electric car company might be much different than a bank. IV percentages give more context than absolute IV figures.
- IV percentages give a measurable statistic: Using a percentile can take emotion out of a trade as opposed to using a non-statistical method to determining whether an option is rich or cheap.
Cons
- Lookback periods matter: A historical volatility range over, say, a one-year period will give a very different sense of potential outcomes if that period included a black swan event such as the Financial Crisis or outbreak of a global pandemic.
- Holidays: Volatility on many products declines around holidays such as New Year's, leading to options being cheaper than during the rest of the year.
- Weather: On commodities such as natural gas and agricultural products, certain months of the year tend to be far more volatile than others. Trades based on IV percentages might fail to account for this.
- Earnings: For stocks, IV tends to be high around earnings reports. A trader may need to adjust an IV percentile or rank reading if a trade is happening going into earnings.
Where To Find the IV of a Stock or Fund
Many websites and financial screeners include the IV of a stock as one of the key statistics or data points that they display. Some screeners allow users to sort by volatility, allowing traders to look for options which may be particularly cheap or expensive to put together trades aimed at profiting from those outliers.
Within most brokerage software applications, there are tools to see the IV of individual options on a given stock, index, or ETF. Depending on the brokerage platform, there may be charts showing the volatility of various options on a given stock over different strikes and expiries. Some brokers also allow clients to enter limit orders based on given IV levels as well, saying for example to buy this option if it hits an IV of 20 or sell it if it reaches 40 or whatnot.
Note: Many brokerages have IV calculators and various related features built into their platforms. These may be hidden by default, so it's worth checking for advanced quotations, risk navigators, and trade modeling sorts of features within a platform where many of these some specialized functions often reside.
Bottom Line
Implied volatility can be associated with a lot of jargon and complicated formulas. With a little study, however, traders can learn to incorporate IV and related concepts into their option trading to maximize the potential returns of their trades.
This article was written by
Ian worked for Kerrisdale, a New York activist hedge fund, for three years, before moving to Latin America to pursue entrepreneurial opportunities there. His Ian's Insider Corner service provides live chat, model portfolios, full access and updates to his "IMF" portfolio, along with a weekly newsletter which expands on these topics.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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