In the first article we discussed how options offer high probability strategies so that non-professional retail traders, like Karen the Super Trader, can make consistent income. The second article covered why trading the SPX, as Karen does, is the optimum approach when trading high probability strategies. And in the third article we discussed the Probability Model, and how it is used to objectively locate your short strikes. The fourth article covered how News (or newsworthy events) affects the markets. In this fifth and last article in this series, we will discuss IV (Implied Volatility) Ranking.
In Option Basics - Part 4 we discussed volatility and its importance.
First, let's define what IV Ranking is. For every option chain of an underlying (asset, index, future, ETF, etc.), there is a calculated implied volatility (most option platforms provide this information). By comparing the current IV for the option chain with the IV range over the last 52 weeks (its highest and lowest values), we can determine where within that range it falls as a percentage. When employing option strategies that generate premium (i.e., credit spreads, naked shorts, iron condors, strangles), the greater the IV, the higher the premium and the further OTM (out of the money) the short strikes.
The equation for IV Rank as a percentage is:
100 x (current IV - 52 week low IV) / (52 week high IV - 52 week low IV)
So, how can IV Ranking help us? It helps us with the selection of underlyings (with liquid options) we may wish to consider trading. The notion is that underlyings with high IV rank (over 50%) are safer to trade because we expect IV to shortly revert or collapse (which would help our position).
Testing has revealed that this improves outcomes dramatically. Tasty Trade did a test recently (see video under Market Measures, Implied Volatility Range Tested (6/19/13) ) which compared outcomes (touched or exceeded the short strike) for four levels of IV Rank in the SPY (an ETF of the S&P500): < 25%; 25% to 50%, 50% to 75%, >75%. This test was conducted using 5-years of data, from June '08 to June '13, with the short strikes at 1 std deviation (the expected move was calculated using the VIX when the trade was initiated at the Close).
The results: the SPY trade touched or closed ITM (in the money; a losing trade) 5x for a ranking <25%; 2x for 25% to 50%; 1x for 50% to 75%; and 1x for <75%. Touched simply means that the SPY did exceed the short strike, but then reversed and closed OTM. The breakdown between touched and closed ITM was: 25.42% touched; 15.25% closed ITM. As we can see, the higher the IV Rank, the lower the risk; with minimum risk occurring at 50% or above.
Of course, whenever we reduce risk, there is a tradeoff. When using high IV Rank (50% or greater), the tradeoff is that there will be far fewer trades. To determine this effect, Tasty Trade ran another test using 60-months of data and thirteen underlyings: SPY, QQQ, IWM, GOOG, AAPL, NFLX, and EBAY (see video under Market Measures, High IV Rank Occurrence (11/11/13) ).
The results: the average percentage of the 13-underlyings was 38.97%. This means you can expect to trade about 5-underlyings per month (on average). Of course, during a strong bull market (which we are currently experiencing), that number could drop to zero.
In conclusion, high IV Ranking (50% or greater) can be effectively used to locate underlyings (with liquid options) that represent low risk trades. However, if you simply trade the SPX (like Karen), then IV Ranking will not play a role in initiating a trade (because of infrequent occurrence); instead, it may encourage reducing the duration of the trade as an alternative to reducing risk.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.