In response to last week’s Options Report, Mario had some great questions surrounding implied volatility and implied volatility rank.

I’m going to address his specific questions here, but if you want to take a deep dive on the subject, I suggest reading the variety of articles on this page. They all cover different facets of implied volatility.

Question One: Which metric takes priority – implied volatility or implied volatility rank?

The answer is implied volatility rank (IVR). In fact, to save space on my charts, I don’t even track implied volatility (IV) as a separate indicator anymore. I just plot the IVR. Here’s why. Implied vol tells you the general level of volatility for a stock’s options. But IVR tells you if that reading is currently high or low relative to its one-year range. That’s the more relevant piece of information.

Currently the S&P 500 has an implied volatility of 28%. Any individual stock with an implied volatility higher than 28% has options premiums that are priced more expensively than those on the Index. For example, Tesla has an implied volatility of 100%, or roughly 4x what SPX options are trading for.

I can state, unequivocally, that TSLA options are more expensive than SPX options. But are they priced higher than they normally are? Is 100% a high IV for TSLA or is it low? I don’t know unless I look at the range that Tesla’s IV has traded in over the last year. The IV Rank or IVR reveals this. Tesla’s IVR is currently 42%. That means its options are trading in the 42nd percentile of their one-year range. Remember, anything below the 25th percentile is cheap. So TSLA options are NOT cheap right now. But they’re not the most expensive they’ve been either.

And I didn’t know this by just looking at the implied volatility reading of 100%. I had to put it in context by also viewing the IVR.

The general rule is you want to see an IVR below 25 for trades where you are buying options, like long calls or bull call spreads. Alternatively, you want to seen an IVR above 50 for trades where you are selling options, like naked puts or credit spreads. This is true whether the implied volatility is 100% or 20%.

Question Two: Can I enter a long call if the IVR is below 25 and IV is above 50?

Yes. The IVR below 25 means options are cheap, regardless of where IV is.

Question Three: Can I enter a long call if the IVR is above 25 and IV is below 50?

This question is a bit trickier. First of all, it doesn’t matter what the IV is. It’s all about the IVR (hopefully I’ve made that clear by now). So I read this as, “can I enter a long call if IVR is above 25?” In other words, can I buy a call if options aren’t exactly cheap? I’d say the answer is maybe. I don’t view IVR as the only variable that goes into my decision-making. So, it’s not automatically a dealbreaker if IVR is above 25 and I’m considering buying options. But there’s no doubt that the ideal scenario for long calls would be to have the IVR sub-25.

It also might depend on how much higher the reading is than 25. Is it 30? If so, I don’t think it’s as risky to buy calls. But if the IVR is 95, I guarantee I’m not purchasing options. I would have to do a spread because they aren’t just not cheap, they’re really expensive.

Key Takeaways

First: IVR is a more useful metric than IV.

Second: When IVR < 25, options are officially cheap. Strategies like long calls/puts, and debit spreads are more attractive.

Third: When IVR > 50, options are officially expensive. Strategies like short calls/puts, and credit spreads are more attractive.

Fourth: You have to decide at what point and IVR above 25 becomes a deal-breaker for long option trades. Is it at 30? 35? 40? It’s a sliding scale, and there’s a lot of middle ground. Maybe you shift from long call if IVR is less than 25 to bull call if it’s between 25 and 50 to bull put if we’re above 50.

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