How to Trade Volatility effectively
For traders it is important to know how to trade Volatility. What is it and how can you use it?
When the stock moves up and down Volatility increases. While uncertainty increases the option premium increases. This change of the stock option premium always is exaggerated. And the experienced trader knows that the the price will have a mean reversion.
Why is this important? Options are insurance contracts, and when the future of an asset becomes more uncertain, there is more demand for insurance on that asset. When applied to stocks, this means that a stock’s options will become more expensive as market participants become more uncertain about that stock’s performance in the future.
When the uncertainty related to a stock increases and the option prices are traded to higher prices, IV will increase. This is sometimes referred to as an “IV expansion.”
On the opposite side of IV expansion is “IV contraction.” This occurs when the fear and uncertainty related to a stock diminishes. As this happens, the stock’s options decrease in price which results in a decrease in IV.
Implied Volatility is a standardized way to measure the prices of options from stock to stock without having to analyze the actual prices of the options.
How to trade Volatility
Mean reversion is the tendency of a stock price to move toward its average over time. If we apply that definition to volatility, then we assume that an option’s volatility will tend to move toward its average over time.
A mean reversion trade expresses the thesis that an asset has deviated too far from its real value. This creates opportunities to make profit. Profit is created when reversion to the mean occurs. By selling option premium you benefit from it.
As noted in a recent episode of Options Jive, mean reversion in options trading is best understood through the lens of historical and implied volatility.
Historical Volatility: Every stock has a specific opening and closing price for each trading day of its existence. That data is used to compute what’s known as historical volatility. It measures the amount the price of a stock has varied over a defined period of time.
Implied Volatility: Modern Investors Trade Volatility. They search for stock options with high Implied Volatility and sell option premium. On Dough it is very easily to spot these options or use the Think or Swim platform. Implied volatility is derived from current market prices and reflects the market’s expectation for movement in the underlying over the duration of the contract.
Example of Volatility trade
Let us look to Trade Volatility. Stock ABC has a one month historical volatility of 20. If options with a one month duration in XYZ are trading with an implied volatility of 29, an opportunity exists. A trader will sell that option with the expectation that actual volatility in the upcoming one month period will be less than 29. It will be most likely closer to 20.
It does not mean that profits is 100% assured, because future volatility is unknown. However, it has been observed that options prices are mean reverting on average. Consequently, a portfolio driven by a high probability strategy such as this should be profitable, on average, over time.
Where do you learn and trade volatility? On the tastytrade network, they often leverage Implied Volatility Rank, or IVR, to help identify these opportunities.
Implied Volatility Rank (IVR) tells us whether implied volatility is high or low in a specific underlying based on the past year of implied volatility data. For example, if XYZ has had an implied volatility between 30 and 60 over the past year and implied volatility is currently trading at 45, XYZ would have an IVR of 50%.
When IVR is high (above 50%), we can expect a contraction (Mean Reversion). When IVR is low (below 50%), we can expect an expansion. Looking at IVR is a best practice at selloptionpremium.com because it provides context to the implied volatility of an underlying (stock).
Implied Volatility Rank helps us decide whether to use a credit or debit strategy. While other considerations need to be taken into account, an IVR above 50% might be indicative of good options selling opportunities, while an IVR below 50% might be indicative of buying opportunities – both due to the mean reverting nature of volatility.