Chapter 1: Volatility as a separate asset class
Many advanced traders don't bet on the stock's direction but on volatility itself: implied volatility (IV) rises and falls for its own reasons, so a trade can be built on it whichever way the stock goes.
A steady pattern in the data: implied volatility (IV) is higher most of the time than the realized volatility that actually occurs (Realized Volatility). The gap is the price of insurance: put buyers pay it to their sellers.
| Measure | Historical value (S&P 500) |
|---|---|
| IV average (VIX), historically | ~19% |
| Average realized volatility | ~15% |
| Average volatility premium | ~4 points (varies) |
How do you read an implied volatility number?
Implied volatility is an annual rate. To convert it to one month, divide it by the square root of 12: an implied volatility of 20% means the market prices a monthly move of about 5.8% (20 ÷ 3.46). So for a stock at $100, the price a month from now lands between $94.2 and $105.8 in about two-thirds of cases, if the normal distribution the formula assumes holds.
IV Rank
IV Rank shows where current implied volatility sits within its one-year range: (current − low) ÷ (high − low). If the low is 15%, the high is 45% and the current level is 30%, the rank is 50: contracts are halfway up their yearly price range. A rank above 50 means premiums richer than usual, and below 20 means cheap premiums.
Three ways to trade volatility
- Buying volatility: a Straddle or Strangle, when the stock is expected to move more than the market prices.
- Selling volatility: selling contracts or an Iron Condor to collect the volatility premium when contracts are expensive.
- The gap between two dates: the calendar spread, which is the topic of the next chapter.
A systematic options seller collects this gap again and again, but is exposed to a rare extreme event (Tail Risk) that can erase months of gains in one day, so protection against it is needed. That happened, for example, in February 2018, when the VIX index doubled in a single session.
Summary
Implied volatility is the price of the movement the market expects, and it can be bought and sold like any asset. Its premium over realized volatility tends to favor the seller most of the time, but it is sometimes paid out all at once on one extreme day. So reading IV Rank before any options trade tells you whether contracts are cheap or expensive.
