Implied Volatility: High or Low?

I sell volatility short. Simple as that.

My job as a trader to to find a stock or fund symbol with high implied volatility on its options, and to sell that volatility at a high price in the hopes of buying it back low price later on.

I do it by selling iron condors — a bull put spread and a bear call spread tied together in a single conceptual structure — usually using the iron fly variant, where the short legs of both spreads have an identical strike price. My profit relies on the premium I receive and on how wide I can reasonably make the wings of each spread.

I often think of it in terms delta, placing the short legs around delta 50 and the long legs around delta 10. (See the table in any of my recent analyses for an example of how I think about it.)

But how high must volatility be before it’s high? And how low is too low?

Important questions without a clear objective answer. Let’s explore some possibilities.

One place to look for answers is history. If the implied volatility, or IV, is in the upper half of its range for the year, then relative to that range, it is high. Or if the IV is in the upper half of its most recent fluctuation from a lowest low to a highest high, then it’s high. Below the 50th percentile, it is low. And of course, the percentile can be adjusted to whatever level seems useful, say the 60th percentile if I need to pick and choose carefully or the 40th percentile if I’m short of trading prospects.

A second place to look is the IV relative to the VIX, which is the implied volatility of the S&P 500. It’s an easy calculation: Divide the current IV of whatever symbol is under consideration by the VIX. The answer you get tells you how many times the VIX the symbol’s volatility is. For example, in today’s analysis of LOW, I found LOW’s IV was 2.5 times the VIX, a reasonably high level compared to the blue chips as a whole.

Which to choose? Let’s consider the uses of implied volatility in a trade.

When volatility is high, I can expand the zone of profit — the width of each spreads wings. This both increases the premium I receive when I sell the position, providing greater protection against loss. This is true whether volatility is stable, rising or falling.

When I sell volatility at a high price and then volatility falls to a lower price, that allows me to exit the position at a lower price, thereby allowing me to keep more of my premium. I.e., more profit.

In either case, I will make money over time because of time decay, the reality that out of the money stock options are worth less as their expiration approaches.

In those three facts, I think, lies the answer.

Volatility rises prior to earnings announcements, and falls thereafter. That fall from prior levels increases my profit, and therefore I want to enter positions where IV is at historically higher levels relative especially to the current swing, with a secondary interest  that it also be higher within a longer period, such as the past year. Time decay will also be a source of profit.

For pure volatility plays, such as on an exchange traded fund or a stock that is distant from its next earnings announcement, there is no guarantee that implied volatility will fall within the lifespan of the position. Therefore, time decay will be the main source of profit.

From this I conclude that implied volatility relative to the VIX is just as important in selecting trades as is volatility relative to a symbol’s historical IV. Indeed, when trades are scarce because implied volatility is low, a symbol whose IV is a multiple of the VIX can be an attractive trade.

As earnings season winds down, i shall be looking at the VIX multiple of my trading prospects in order to test my reasoning and, I hope, find more trades.

By Tim Bovee, Portland, Oregon, May 23, 2017

Appendix:

A list of today’s VIX multiple of liquid exchange-traded funds, sorted in descending order by the multiple.

sym vix multiple
EWZ 3.76
GDXJ 3.58
UNG 3.12
GDX 2.85
USO 2.85
XOP 2.85
OIH 2.57
XBI 2.30
KRE 2.11
SLV 1.93
EWW 1.93
XRT 1.74
XLE 1.65
EEM 1.47
IWM 1.47
FXI 1.47
XLF 1.47
XHB 1.38
VWO 1.29
XLB 1.29
QQQ 1.19
XLI 1.19
XLK 1.19
IYR 1.10
VNQ 1.10
GLD 1.10
XLU 1.10
XLV 1.10
SPY 1.01
EFA 1.01
VGK 1.01
XLP 1.01
XLY 1.01
TLT 0.92
DIA 0.92
HYG 0.64

 

 

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