IV RANK AND PROBABILITY
Volatility and Implied Volatility Rank (IVR) - The Key to Options Success
The goal of options trading is to sell options and collect premium income in a consistent and high-probability manner. Enabling your portfolio to appreciate steadily month after month without guessing which direction the market will move. The main key for options trading success is leveraging implied volatility and time premium decay to your advantage. Since options premium pricing is largely determined by implied volatility, it's this implied volatility component when used appropriately that provides options traders with a statistical edge over the long-term.
Implied volatility is the market's prediction of how volatile the stock will be in the future or the expected volatility of a stock. Implied volatility has many implications and relationships that should be grasped.
The higher the IV, the wider the expected range of the underlying stock movement becomes
As IV rises, the expectations of share price movement rise and demand for the options increase
When IV increases, options increase in value
When IV decreases, options decrease in value
Since option pricing is determined by IV, the option itself will rise and fall as IV or the expectation of volatility changes. IV largely determines whether or not options are relatively cheap or expensive. Historically, this predicted volatility always overestimates actual volatility and it's this overestimation that can be exploited to the benefit to option sellers, providing that edge.
Put simply, if the market predicted that a stock was going to move 50% in either direction when looking back at the actual move, the stock may have only moved 40% in either direction. Put another way, at the beginning of a 30-day period, IV is predicted for the equity's move over the course of the next month. However, when looking back and comparing the actual volatility after that 30-day period it is nearly always lower thus IV is overestimated.
Thus stocks are less volatile than predicted! Therefore, the value of options contracts is nearly always high relative to what the actual stock move reflects. This overestimation is where options traders can take advantage and sell overpriced options to maximize profits and probability of success over the long-term.
How can we use IV to our advantage in options trading? This is where IV Rank comes into play and how this is the most critical variable in options trading and its success over the long-term. IV Rank is a measure of current implied volatility against the historical implied volatility range (IV low - IV high) over a one-year period. Let's say the IV range is 30-60 over the past year, thus the lowest IV value is 30 and the highest IV value is 60. We need to compare the current IV value to this range to understand how the current IV ranks in relation to its historical IV range. If the current IV value is 45, then this would equate to an IV Rank of 50% since it falls in middle of this range.
IV Rank = (current IV - 52-week IV low)/(52-week IV high - 52-week IV low)
IV Rank is used to determine when option pricing is relatively pricey or cheap compared to its historic implied volatility for a specific security. When IV Rank approaches a value of greater than 50 then option sellers can use this to their advantage to take in rich options premium with the expectation that this implied volatility will decrease. Any value above the 50 threshold is where the overestimation of actual volatility thrives and options sellers can take in rich premiums with the expectation that IV will fall thus the option itself will fall in value. This provides an opportunity to sell options with rich premiums and as IV falls, the option can expire worthless and/or the seller can buy-to-close to realize profits prior to expiration.
Rich premiums can be paid out to option sellers with the expectation that volatility will revert to its mean. Allowing the option to decrease in value and expire worthless at expiration even if the underlying stock moves up, sideways or down without breaking through the strike price in a high probability manner. Selling options in these high IV Rank situations serve as a two-fold benefit since time premium is always evaporating and IV will likely revert to its mean and fall. Even if the stock moves up, down or trades sideways without breaking through the strike, the option will be profitable as time and IV fall.
The high IV Rank provides rich premium and as the option life-cycle unfolds and this volatility decreases, the option time value implodes and the option decreases in value allowing profits to be realized earlier in the life-cycle without waiting until expiration of the contract. Leading to consistent income generation in a high-probability manner without guessing which way the stock will move.
Picking the right direction of the market is a binary event and boils down to a 50/50 probability when compared against the movement of the S&P 500 and Dow over the long-term. The number of consecutive daily moves in either direction is nearly evenly distributed thus moving in a standard distribution over time. The Dow has fluctuated between a 2% loss and 2% gain 94% of the time and between a loss of 0.7% and gain of 0.7% of the time on a daily basis since 1900. There's an equal and even number of days when the market moved up 1% as it moved down 1%. There's no patterns or predictable cycles over a long term basis equating stock picking to random chance and a 50/50 probability (see S&P 500 distribution of returns below). The only way to profit from this even distribution and behavior of the market is via options trading. Options allow one to dictate his probability of success and thus profit without estimating what direction the market will move. Options trading isn't about whether or not the stock will go up or down, it's all about the probability of the stock not moving up or down more than a specified amount based on probabilities respective to the underlying market or equity. Options are a bet on where the stock won't go, not where it will go.
Based on all historical moves and magnitude of moves a stock has made in the past, its future absolute move (positive or negative) within standard deviations are predicted. Implied volatility (IV) is used to predict the future magnitude move of the stock over a given timeframe.
High IV Rank leads to overpriced or richly valued option contracts where option sellers can capitalize since implied volatility is nearly always overstated and the actual move of the underlying stock will be less volatile than predicted.
Delta is a proxy for probability of success thus a delta of -0.15 in absolute terms is 0.15 or an 85% probability (1.0 - 0.15 = 0.85) of the option expiring worthless at expiration. Translating this into standard deviations, one standard deviation captures 68.2% of all future stock movements while two standard deviations capture 95.4%. Selling a put contract at ~0.15 delta is roughly setting the strike 1 standard deviation out of the money since 68.2% resides within the 1 standard deviation and 13.6% remains in the second standard deviation in the positive direction of probability. Sticking with 2 standard deviations and not assuming any outliers, 100% of all stock movements less the second standard deviation in the positive direction and less the one standard deviation in both directions we arrive at a Delta of 16 or an 82% probability of the stock not moving below this price (100% - (68.2% + 13.6%)). Coupling the probabilities with rich IV in an option selling environment is the key to options success.