Using IV Rank to Choose Better Trades
Recently, we discussed the powerful effect of implied volatility (IV). It can wreak havoc on traders that don’t understand it and can take even a well-performing, profitable trade right to the dumpster.
Conversely though, those that do understand how to use implied volatility can have it work wonderfully to their advantage. For instance, if a trader are bullish on shares of ABC, they could initiate a credit trade. In this event, even if the stock doesn’t move, or even in some cases if it moves lower, the trade can still be profitable.
How can this be? One part of a profitable credit trade is time decay. But another part of a profitable credit trade can often times be centered around implied volatility.
Buyers and Sellers
It’s not just credit collectors that can profit from implied volatility, provided a trader understands how to use it. Just like credit collectors can sell into high volatility situations and look for that volatility to dissipate, debit buyers can buy low volatility situations.
When volatility is on the low side for a particular stock, an increase in IV can quickly add massive gains to certain option positions, (provided that the stock is moving in the desired direction as well).
Wouldn’t it be nice to scan for stocks that fit within a certain volatility range? Oh wait…
Using Option Party’s IV Rank Feature
Once investors find themselves on the pre-scan page, they have an array of choices. Aside from adjusting their multiple risk and return probabilities and minimum trade returns — more can be read about these important probabilities, here — traders will find themselves looking at another set of criteria.
After adjusting the time horizon of the trade, the various strategies and how much they’re willing to risk, traders come across “Implied Volatility.” Once clicking on the Implied Volatility tab, the first option users will see is IV Rank. There are other options, but for now, let’s just stick with the first one. IV rank allows us to weed out ETFs and stocks based on what its current IV is vs. its one-year average range.
So how does it work?
First let’s talk about the range. Every five minutes, Option Party calculates the average implied volatility. If the IV measurement makes a new high or low, it is then recorded as such. Think of it like a 52-week range for a stock price. When a stock makes a new high or low, the range is then extended either higher or lower.
Is the stock within 5% of its 52-week high? How about within 20% of its 52-week low? That’s the sort of principle we’re applying — only in this case, we want to know within what range the current IV is resting.
In our case, the IV Rank sits between 0% (the bottom) and 100% (the maximum). Thus, if we only wanted to scan for stocks trading within the top 20% of its one-year IV range, we would set the scanner for a minimum of 80% and maximum of 100%. Conversely, if we were looking for IV setups that were trading near their historic average low, we would scan between 0% and 10%. As a result, we would only receive stocks that are trading within 10% of the lowest IV range for each particular security.
Let’s say we’re looking for high volatility trade setups, so we set our minimum at 80% and our maximum at 100%. What exactly does this mean? This means we’re scanning for stocks that are in the top 20% of their own historic IV range over the past year. For instance, if shares of JLK have a one-year IV range of 50 to 90, the top 20% would be for an IV reading of 72 through 90.
That’s what Option Party will be scanning for — to find trades that are between the constantly calculated IV range. And that’s specifically what IV Rank was built for.
If JLK’s current IV reading is 65, it will not turn up in our IV Rank scan. However, if JLK’s current IV reading is 86, that falls within the 80th percentile, and therefore would be included on the results page, (provided it has met our other scan criteria). Think of IV Rank to being similar to percentiles in a test group. What group do we want to seek out — those at the bottom of the range? Top? Somewhere in between?
Doing It Differently
It seems like investors could have an easier method. Perhaps, why not scan for stocks for that have an actual IV reading between 50 and 75? While simple on the surface, this method actually ignores a huge portion of stocks and also isn’t very representing of the bigger picture. For instance, a low volatility stock like GE may be overlooked. Just because it doesn’t trade with a volatility as high as Twitter, for instance, doesn’t mean that for all we know, GE is trading with its highest IV figure in the past year.
It also excludes or includes certain types of stocks. For instance, using the same example above, let’s say we scan for stocks with an IV reading between 50 and 75. Keep in mind, this is scanning the actual IV measurements, not their ranges like in our “Let’s See an Example” portion.
A reading between 50 and 75 could exclude sectors that are known for high volatility, like biotech. This is true even if the volatility for a particular stock is abnormally low. If the range for XYZ is 80 to 175 and its current IV reading is 82, then this stock is low in volatility based on its one-year range. However, it wouldn’t be included because this “high volatility” stock doesn’t show up in this 50 to 75 range, despite being near its lowest IV ranges in a year.
That’s why it’s important to look at each stock in the context of its current range. Because basing Twitter’s IV range alongside GE’s just doesn’t make any sense. It’s apples to oranges. Option Party wants you to know and be able to scan securities against their average IV range, in order to see if it’s near an extreme end of the spectrum. From there, we can search for alpha.