One of the questions which always haunts an options trader is: is an IV too high or too low. And how do you know if an IV is high or low? 25 is a high IV for an Index, 30 is low for a large-cap stock, and even 80 is not too high for a highly volatile smallcap. So how can you tell if an IV is high enough to sell or low enough to buy?
What is IV percentile and how is it calculated?
IV percentile (IVP) is a relative measure of Implied Volatility that compares current IV of a stock to its own Implied Volatility in the past. Put simply, IVP tells you the percentage of time that the IV in the past has been lower than current IV. It is a percentile number, so it varies between 0 and 100. A high IVP number, typically above 80, says that IV is high, and a low IVP, typically below 20, says that IV is low.
You can see all the IVs and IV percentiles of all the stocks here:
Option Chain by Sensibull — trade.sensibull.com/optionchain
Option Central by Sensibull trade.sensibull.com/central
How is IV percentile useful in options trading?
Let us take an example. DABUR has an IV of 25.1, DHFL has an IV of 91.4 and INFIBEAM has an IV of 156.9! IV can be more than 100 in extreme cases. Simply glancing at the IV itself does not give us any useful information. Is this IV high or low? Should I buy or sell this option? How can I understand these IV numbers in a meaningful way to get tradeable insights?
The answer is IV percentile (IVP). It can be seen above that PCJEWELLER has an IV of 95.6. As the IV number is huge, it is easy to mistake this for a high IV stock. However, looking at the IVP shows the bigger picture. The IVP of 51 reveals that the current IV is actually not high for PCJEWELLER. Rather, it is near its average historical volatility. So an IV of 20 can be high for Nifty, but an IV of 60 can be low for PCJEWELLER.
How can we use IVP?
Should I buy or sell options:
When volatility rises, option prices rise and option buyers gain. When volatility falls, options prices fall and option sellers gain. This logic holds for options strategies like straddles and strangles as well. It also holds for spreads when the strike prices are not close. Spreads with close strikes prices are almost vega neutral. Generally speaking, credit strategies (receive net premium) are short volatility and debit strategies (pay net premium) are long volatility.
Therefore, the rules to keep in mind are:
- Debit strategies are better in low IV conditions.
- Credit strategies are better in high IV conditions.
- Credit strategies are better avoided in low IV conditions.
- Debit strategies are better avoided in high IV conditions.
- Looking at IV percentile before buying or selling options can indicate if our strategy is likely to go wrong.
Short volatility trades:
The options trader’s view on volatility determines whether to enter debit or credit strategies. For example, the volatility in a particular stock may have built up in the days preceding the announcement of results. A trader who expects IV to crash post announcement of results could profit from the drop in IV by entering into a credit strategy (short strangle or straddle) before the result and exiting after the result.
When does IV percentile work, and when does it not work?
Remember that there are no absolutes in trading, and IV percentile is not a magic number to analyse options. It has its own limitations.
Long/short volatility trading works well when the volatility has a tendency to revert to its mean. That is when extremely low or high IV conditions are not persistent and the IV tends to move towards its mean HV after times of extreme high/low IV. However, there can be periods of extended and persistent high/low volatility. In these situations, long/short volatility strategies may not work. Also, sometimes these strategies take time to become profitable — the rise/fall in volatility may take longer than expected, and the effects of theta and delta may negate the profits from vega. Remember that IV swings up and down just like prices and is almost extremely difficult to predict.
Finally, IVP does not work well too close to the expiry, as Vega is very low on very short-term options and low Vega leads to very high IVs when any move happens.
You can see how IV and days left to expiry interacts with Vega and changes your Option Price using the Custom Strategy Builder by Sensibull — trade.sensibull.com/builder
Summary
In conclusion, IV percentile is a useful indicator to quickly identify whether a particular stock’s IV is high or low. This, in turn, can tell us whether a debit or credit strategy is the prudent choice in the situation. However, just like anything else in trading, it is not something to be blindly followed. All other factors must be considered before entering into a position.
By Srujan, Product Manager At Sensibull
