Welcome back to our Morning Mailbag where I take questions from twitter, facebook and our email and respond so that the community can learn together. This installment involves IV%. Enjoy!
Hi Natalia,
Implied Volatility is a hot button subject that options traders tend to talk about quite a bit. IV% is calculated through the Black Scholes model. I won’t bore you with the math on it. For the purpose of this email, I’ll try to simply explain it in a way that you can use it. Here goes!
In many option books, classes and webinars you’ll hear traders say that IV% should be higher when selling options and should be lower when buying options. That is true. But to define high and low is the tricky part. For some stocks 30% is a high IV. For other stocks 30% is a low IV. IV is relative to that stock alone. So when you say that your stocks are generally in the 20-30% IV range that’s fairly reflective of the average stocks on the market right now. To establish a base average, traders use the Volatility Index (VIX) which measures the IV for the S&P 500. This doesn’t reflect all stocks in the market though. On Friday’s close 1/9/2015, the VIX was trading at near 17.00. But most of the stocks you’re trading are in the 20-30 range. Why? Well because individual stock IV is generally higher than indexed stock volatility. That’s because any one stock has more independent and random risk than the overall index.
The best way to explain what you want in IV is to call it Bullish or Bearish instead of Low or High. When IV is Bullish you want to be a buyer of options. What does that mean? Let me dive into some examples.
If the IV of one of your stocks is 25%. And you believe it will rise to 30 or 35%. Then you are bullish on that IV. You want to be a net buyer or what we call in the biz, positive vega. The fact that its 25% doesn’t tell you whether to buy or sell. Because in that same example if you thought IV% would drop from 25% to 15% then you need to be a net seller of options. The number itself doesn’t tell you enough about the IV to make a decision on whether to buy or sell.
But, by looking at IV trends and understanding the relationship IV has to earnings (probably best saved for another post) you can make educated guesses on where IV will move over time. That way you can select your strategies. So the simple answer – is to NOT look at the IV% number alone – but to make a decision on where you believe it will move over time before you trade.
The probability of out of money % is simply a mathematical result from an Algorithm that brokerage softwares use. They put this number in there to help traders further dig into their options probability and risk. I think you should hold off on trying to use that too much until you understand the concept delta fully. Use delta first, then these other tools afterward.
Thanks for the questions!
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