How Leveraging Implied Volatility Can Vastly Improve Trading Plans
So often — far too often, in fact — traders and investors overlook IV in their trading strategies. The reasons for doing so vary. Some find IV too complex and either don’t understand what it measures or don’t know how to effectively use it. Others use time frames that they believe render IV meaningless, or least unimportant enough to make a central focus point in their scheme. However, leveraging implied volatility can give you an advantage in your options trading.
What they’re doing though could be costing them plenty of performance. An experienced investor or trader knows that by effectively using IV, they can potentially add mountains to their returns. Perhaps more important than boosting their returns though, they can also avoid dangerous pitfalls in the IV arena that novice or careless traders may fall victim too.
For instance, a novice trader may buy a call option thinking that more upside exists in a particular stock. However, if its current IV is trading at a historically high level, it may very well make more sense to be a seller in this circumstance. In its simplest form, if that implied volatility dries up over the next few days or weeks, it will bleed premium from the option’s price, (draining the value of the call option in this case).
We recently discussed a new implied volatility feature within the Option Party platform called IV Rank. This feature is an excellent new addition for those who focus on looking for specific setups based on volatility or those that are at least conscientious of IV when taking positions in the market — however long- or short-term those positions may be.
In short, IV Rank lets users sort through a number of securities based on where its current IV stands vs. its one-year historic average. The measurement is taken on a 0% (minimum) through 100% (maximum) range reading. After putting in all of our other requirements — minimum probabilities of return, maximum probability of total loss, strategy type, expiration range and all the good stuff, we can screen by volatility as well.
For instance, if we’re looking to sell premium we may want to look at securities that are in the top 15 percentile of its one-year IV range. In that case, we would enter 85% to 100% as our IV Rank range. Meaning that if shares of ABC have a one-year IV range of 50 to 125, ABC will only turn up in our results if its current IV reading is at or above 106.25 — the top 15% of its one-year range.
Now, Consider IV Preference
When using the IV Rank feature, we are looking for a range. Each stock has a one-year range of highs and lows when it comes to implied volatility and Option Party’s feature can find stocks within certain areas of that range. Whether we’re looking for stocks near the lows, near the highs or somewhere in the middle, IV Rank can find it.
However, sometimes traders are looking for a certain type of stock via implied volatility. Meaning, they’re not just searching for stocks based on where they are in an IV range. Instead, they want low volatility stocks, high volatility stocks and a bevy of options in between. Maybe they only want stocks without high volatility. Perhaps they only want stocks with medium to high volatility, just not low volatility.
That’s where IV Preference comes into play.
For example, let’s say I’m a trader that doesn’t want a low volatility setup. I’m fine with normal volatility and I’m good with high volatility. I just don’t want a low volatility setup. And remember, when working with IV preference, this is not on a range of 0% to 100%. Instead, measures actual implied volatility, which can be far above 100 in some instances.
So in our scenario of wanting medium to high volatility, I could set an IV preference for implied volatility that is greater than 40%. With this filter on, any option that fits the rest of my scan will also have to have an IV of 40% or higher. If it’s less, it won’t show up.
Traders who only want low volatility can do the same thing, setting an IV preference of lower than 40, for instance. In this case, only low IV setups that make it through the rest of the filters will show themselves.
Let’s Do Some Combining
This is where the true beauty of Option Party’s features come into play. Since there are no mutually exclusive filters, investors can scan to have the best of both worlds. Want a low-volatility stock that’s trading within the top 25% of its one-year IV range?
Simple. Just set the IV Rank at 75% to 100% to scan within the top 75th percentile of the one-year range. Then, set the IV Preference at “Less Than 45,” or whatever implied volatility level the trader would consider “low.” By doing this, traders have immense flexibility when it comes to scanning IV setups, allowing them to troll for low volatility stocks trading in high ranges or vice versa.
We can also look for high volatility setups — say, an IV Preference above 80 — while also looking for stocks in the lower 25th percentile of their one-year IV range — so an IV Rank search of 0% to 25%. This will tell Option Party to scan for high volatility stocks trading at the lower end of its one-year IV range.
We’re going to borrow an example from above, looking for traditionally low-volatility stocks trading near the higher end of their respective IV ranges. Specifically, we’re looking for Bull Put Spreads to take advantage of an elevated IV situation. On the implied volatility front, we’re using an IV Rank of 80% to 100% and an IV Preference of “Less Than 50.”
In our specific case, here’s what we get.
Investors need to be timely when they consider some of their moves, though. For instance, I personally avoid stocks that are about to report earnings and in this case, IBM reports the next day. That puts Alcoa on deck for further investigation. But as one can see, by using IV scans as an additional filter or as a core component to their strategies, investors can vastly improve their screening methods and overall potential. Not only that, they can develop and integrate entire strategies based on implied volatility.