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Based on your feedback, I know many of you found these useful, and some of you even shared your own valuable insights.
One email in particular summed up several I had received, and I felt it was worth an article in and of itself.
Mario V. submitted the following after reading the article on spreads:
How do you know how the implied volatility is moving? What indicator measures it?
This is a great question; I wondered the same thing for years.
The truth is, there is no one indicator or equation that gives you a definitive answer, because implied volatility changes so often across so many different data points.
And no, your platforms don’t store that data either.
As opposed to writing down the implied volatility for each trade you have or option you look up, I’m going to help you work around the problem using the tools we have available.
But first, I want to explain why we can’t simply look up historical implied volatility.
How Is Implied Volatility Calculated?Did you know implied volatility is the only option Greek (measure) that isn’t an input?
Yes, you read that correctly.
Implied volatility isn’t an input; it’s an output. That sounds bonkers since we need it to come up with the price of an option.
Let me explain.
Here’s the basic equation for the price of any option:
We can see the first two items when we select any option out of an options chain.
But implied volatility is actually calculated based on the current option price.
Most options aren’t actively traded, maybe hitting a few hundred or thousand contracts a day in total volume.
If there is no current price, you need to use the bid and ask prices to figure out the midpoint to get an approximation of the option’s current price.
Now imagine trying to do all that for an option that happened in the past, and you understand why neither traders nor brokers keep this information on hand.
In fact, the only way to get that information is to shell out a lot of money to buy the historical “Greek values” from the exchanges. And believe me, that costs a fortune.
So rather than harping on what we can’t do, let’s look at what we can do.
What Information Do We Have?In one of my recent TradeSmith Daily articles, I discussed how implied volatility is measured in three separate ways:
- At an individual expiration and strike level
- At each expiration cycle aggregated across all the different strikes
- At the stock level using a standard 30-day expiration
Unfortunately, the implied volatility at the individual option level and aggregated strike level are not easily available.
However, many platforms and brokers do provide the 30-day implied volatility by day.
And that’s what we’ll use to determine whether implied volatility is high, low, or average, as well as how it has changed over time.
To be clear, not all brokers provide this information, but many do.
Here’s an example from TD Ameritrade’s Thinkorswim platform.
This chart contains a few pieces of information:
- The red and green candlesticks in the top section plot the daily open, high, low, and close of the trading range for Apple each day.
- The blue bar chart behind that represents the volume of shares traded each day.
- At the bottom, the subgraph has a turquoise line that plots the implied volatility for Apple, assuming a 30-day expiration. Each point represents the implied volatility at the close of that day.
- The three light-orange lines at the bottom give you a frame of reference for the trading range of implied volatility.
Using the implied volatility rank calculation, we would get the following:
IV Rank = (30.21% – 21.57%) / (53.39% – 21.57%) = 27.15
Now, let’s say I wanted to evaluate the implied volatility for the March 18, 2022, monthly options cycle. That’s 36 days away (at the time of this writing).
In the chart below, you’ll see that the implied volatility for March is 30.34%, roughly in line with the 30.21% value the platform calculated for the 30-day implied volatility.
With this information, and the chart of implied volatility for Apple, we can say that implied volatility is relatively low compared to the 52-week range and has been trending lower recently.
Plus, if we look at the implied volatility for expirations going out further in time (within the orange box), we see a natural increase. This is typical, as the further you go out in time, the more uncertainty (i.e., implied volatility) gets priced in.
Earnings can play a big part in this as well.
Take a look at the option chain for Zoom Video Communications (ZM), which has earnings coming up on Feb. 28.
Notice how the implied volatility is in the 60s until we get to March. Then it jumps up to almost 90%.
That’s driven entirely by earnings. Traders will price in the unknown movement that comes from an earnings release.
Once that information is released, you’ll see implied volatility collapse.
Check out that same Apple chart from earlier, with earnings releases noted with yellow lines.
If you look at the bottom, you can see how implied volatility declined immediately after each earnings announcement.
However, the impact of that cycle’s earnings declines as you go further out in time because other earnings announcements come into play. Plus, as more time passes, earnings volatility becomes a smaller part of the stock’s overall volatility.
So, while you can use this implied volatility collapse to your advantage, it’s a double-edged sword.
Implied volatility declines have the largest impact with near-term expirations. But options with near-term expirations have more directional risk, meaning they move a lot more rapidly when the stock’s price changes.
Pick any cycle that expires shortly after earnings, and you get the benefit of the implied volatility collapse. But you also get the directional risk from the stock’s movement.
Pick any cycle that expires long after earnings, and you reduce the directional risk from a stock’s movement after earnings. But you don’t get the maximum benefit of the implied volatility collapse.
So Where’s The Sweet Spot?Between 30 and 60 days until expiration, optimally at 45 days.
That range allows you to get the best mix of exposure to implied volatility declines, whether driven by earnings or general stock market behavior, without taking on too much directional risk.
Now, if you really want to add some depth to your trading, start including the implied volatility in your trade journal when you initiate a position.
I wouldn’t bother so much with the implied volatility of the individual options so much as the expiration cycle itself. That way, you can compare the current implied volatility for that cycle to the implied volatility at the time you took the trade and see where you stand.
This article covered a lot of information, so do me a favor. Write to me, and let me know what parts of this clicked with you and where you still struggle to connect the dots.
I want these pieces to be as much about me teaching you as they are about answering your questions. While I can’t respond to every email, I promise to read them all.