Warrior Trading Blog

How to use Implied Volatility (IV) Rank in Options Trading

IV Rank

What is IV Rank?

IV rank or implied volatility rank is a metric used to identify a security’s implied volatility compared to its IV history and is an important metric for day traders. If I were to tell you that a stock’s implied volatility is 50%, you might think that is high, until I told you it was a biotech penny stock that regularly makes 100% moves in a week.

Conversely, you might think that 20% is a low implied volatility level until I tell you that the stock is a low-volatility utility company that hardly moves 5% throughout a year.

 IV rank takes the highest and lowest levels of implied volatility over the trailing 52 weeks and ranks the current IV level relative to those highs and lows. Here’s the formula, taken from TastyTrade:

 100 x (the current IV level – the 52 week IV low) / (the 52 week IV high – 52 week IV low) = IV Rank

For example, if a stock’s 52 week IV high is 100%, and the 52 week IV low is 50%, that would mean a current IV level of 75% would give the stock an IV rank of 50 because it’s implied volatility is directly in the middle of its 52-week range.

 The Implied Volatility rank is kind of like a P/E ratio for a stock. If I tell you a stock is $100 per share, that tells you virtually nothing. You don’t know how many shares the company has outstanding or how much earnings per share the company is producing.

However, if I told you that the P/E ratio is 10, you get much information from that. It says that the earnings yield is 10%, and you can compare it to the P/E ratio of comparable companies as well as the general market.

 The key here is that IV rank provides context.

How IV Rank Affects Option Pricing

IV rank itself doesn’t affect option pricing. Several factors, including determine an option’s price, but limited to:

 IV rank helps us categorize the options of several different securities with different risk and volatility profiles and apply an apples-to-apples comparison. Comparing the pure IV level of Procter & Gamble and Tesla doesn’t make sense.

P&G is a super stable blue-chip stock, while Tesla is a highly volatile growth stock. However, IV rank is an all-things-being-equal metric that tells us where each security is relative to their IV level.

So how does Implied Volatility rank play into this? Just like share price, a stock’s IV alone doesn’t tell us much. It doesn’t make sense to sell an option purely because it has a high IV.

Markets are reasonably efficient, and there’s generally a reason for the high premiums. However, if a stock’s IV is very high or low relative to its IV history, then we have more information.

 If you’re selling premium, you ideally want to sell when IV is high, because then the premiums you collect are high. So, a high IV rank alerts us to a premium-selling opportunity, while a low IV rank might inspire us to buy premium if we have a directional bias on the security. +

 So, in general, a high IV rank means that a stock’s premiums are historically very high, creating a possible premium-selling opportunity. 

Implied Volatility Rank Can Stay High

While a handy metric, IV rank can oversimplify things and make options trading look too accessible to some novices. Many might read the above paragraph and think, “wow, it’s as easy as selling when IV rank is high and buying when it’s low.” There is, of course, no magic bullet indicator, and IV rank is no different in this respect.

 A high IV rank can stay high for a long time, and vice versa. The folks over at TastyTrade point to a pointedly painful moment for many premium sellers: the Brazilian election and the EWZ ETF. The IV rank stayed at 100 for three straight months.

IV Rank Can Sometimes Be Deceiving

If you’re a trader of the US markets, you know that volatility has been exceeding low for the majority of the most recent bull run after the Great Recession. Most of the time, the VIX has been sitting at less than 15. 

Here’s a 10-month moving average of the VIX since the Great Recession. A chart like this, coupled with IV rank analysis, might inspire some to sell premium at levels like 20, which seem very high.

IV Rank

However, before the Great Recession, VIX levels north of 20 were relatively common. If we look back to the dot-com boom of the late 1990s, we can see that the VIX was regularly sitting at 25. So while selling premium on the VIX when it’s sitting at 20 might make sense, it’s still essential to develop a big-picture view and have the necessary historical context. 

Here’s a chart of the VIX before the Great Recession which shows a much different picture from the above chart:

IV Rank

 

Incorporating IV Rank Into Option Selling Strategies

There’s a widespread belief among options traders: “implied volatility is overstated.” This essentially means that the price moves projected by implied volatility are exaggerated and are hardly realized.

If the options traders are correct, this means that when a stock’s Implied Volatility rank is high, it’s unlikely actually to realize that level of volatility. This gives us an edge that we can create a trading strategy based on. In the most basic terms, we can wait for a security’s IV rank to be near 100 and then sell options on it.

The premiums will be high, and the security will be unlikely to realize this volatility, allowing us to keep the premium more often than we lose it. Hopefully, our wins outweigh our losses.

Final Thoughts

Options tools like IV rank and IV percentile are just that: tools. They’re not inherently useful in the same way that an authentic Les Paul doesn’t make a non-guitarist better at playing guitar.

They categorize data in a way that, in the hands of a good trader, can be used to secure massive profits.

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