Understanding (and mastering) the difference between a stock's actual implied volatility and that IV's percentile or rank going back historically is one of the biggest keys to your success. This is because our whole concept of trading options and selecting strategies hinges on this concept of volatility and pricing. Are options relatively expensive or relatively cheap? How do we know? How can we truly compare between different stocks? In this in-depth tutorial lesson I'll go into great detail to make sure you know exactly why simply looking at a stock's IV is not enough. And how you can figure out how cheap/expensive a stocks options are relative to the past. Buckle up because this one is intense.
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In this video tutorial, I want to talk about specifically the differences between implied volatility or IV and implied volatility percentile or IV rank.
Understanding and mastering these differences between the stock’s actual implied volatility and that stock’s IV percentile or rank (going back historically) is one of the biggest keys to your ability to be successful when trading.
This is because our whole concept of trading options and selecting the strategies hinges on this idea of volatility and pricing. Are options relatively expensive or relatively cheap? How do we know when?
How can we truly compare different stocks because not every stock is going to act the same? Implied volatility on one stock may be different than another. One of the ways that we can bring all of this together is using IV percentile or IV rank.
Let’s start by looking at some real estate examples which we can use as a great example to prove this concept and this methodology. Alright, if we have just a general properly that I just picked out at Falls Church, Virginia…
This is a property that was close to where we used to live. We used to live in a little bit different market outside of Washington DC.
As you’re looking at this property from wherever you live in the entire world because we’ve got people that watch these videos from Australia and England and New Zealand, all the way to Canada and Chile, we’ve got people that watch videos from all over the world.
When you look at this property, it’s just a regular house, it’ just like a regular detached regular house, you probably have some number in your head as to what this house might be worth because this house in your area might be worth some different figure than this house might be worth in our area here in Northern Virginia.
Real quickly, just put a price tag on this house just based on what you see. It’s a three bedroom two bath house, 2,500 square feet very average house built in the 1950s. Do you have that price on it?
The price of this house is $595,000, a little over half a million dollars for this house and that maybe a bit higher or maybe a bit lower than what you're thinking in your head.
The point here that we’re trying to drive home is that this is all about where the property is sitting. This particular house sitting on this lot in this location is relatively expensive compared to if you just took this house and picked it up and moved it to say someplace in Pennsylvania or Kansas or the Midwest.
This house maybe relatively cheap someplace else or relatively expensive someplace else, but it’s all relative. We don’t have any frame of reference when we use stocks as to where implied volatility is about itself.
That's one way that we can use IV percentile. You see just like real estate prices; implied volatility is relative for each and every stock. What might seem high might be fairly low for that particular stock going back historically.
Let’s look at a couple of real examples here on the trading platform. Alright, here we are inside of my broker platform on Thinkorswim, and I want to look at Google. This is a stock that we follow a lot.
It’s a very highly liquid stock, big-name stock. Right now, we can track where Google’s actual implied volatility is. This is a quick little indicator that you can add. It’s just a quick study that tracks implied volatility of Google basically over the last year.
You can see this green line is tracking implied volatility over the last year. The current reading of implied volatility is .2607, so 26.07% for Google. That's where it is right now as of this moment in this video.
Looking back historically, you can see that at one point, implied volatility was much higher than it is right now and actually, implied volatility was much lower than it is right now. You can see that it’s middle of the range.
It’s been lower back in August and definitely in May, but it’s also been higher back in October and a little bit here in December of last year. Relatively speaking, we know that this level, this 26.05 level is midrange.
What we can do is we can also throw up an indicator on our charts. We have the code for this at optionalpha.com for members. The code for this is tracking implied volatility percentile.
This percentile up in the top left-hand corner of the screen says that Google’s implied volatility percentile is 44%. What does that mean?
It means that using this number that it's at right now going back all the way over the last year is saying that over the last year, 44% of the time, implied volatility was lower than it is at this exact moment in time.
Again, this number up here is saying that back historically over the last year, 44% of the time, implied volatility in Google was lower than where it is right now, meaning it was lower than 26.05%.
If we take this in the inverse, then that means almost 56% of the time, implied volatility was higher than it is right now. You can see that that was true because implied volatility was higher than it is right now.
This gives us an idea, a frame of reference as to where Google's implied volatility is about itself. Is it relatively low or relatively high? Right now, we would say it’s middle of the range.
Let’s look at another stock to compare. Google's implied volatility right now is 26.05. That's the actual number reading. When we switchover to a chart of GLD, what you can see is that GLD or gold has relatively high implied volatility right now.
You can see just basically visualizing and looking back on the charts here that it’s relatively high going back over the last year. What's really interesting about this is that the actual reading on GLD is 22.08.
You see most traders when they look at implied volatility to judge whether it's high or low will only look at the implied volatility number.
In this case, that 22.08 would signal to somebody if they're comparing Google which had 26% implied volatility versus GLD which has 22% implied volatility, that person would say that Google has a higher implied volatility than GLD and they’re right only in the sense that that number is higher.
But when we look back historically, it looks like GLD or gold has a much higher implied volatility percentile and its implied volatility percentile or rank is at 77%, meaning that 77% of the time going back over the last year from where it is right now lower, implied volatility was lower 77% of the time.
We would say that GLD has relatively high implied volatility right now and it probably makes sense because the stock has been moving high really quickly and rapidly.
This brings down a new level of context and understanding by doing an implied volatility percentile or rank on your charts. You get a better understanding of where implied volatility is in its historical range.
Let's look at one more, taking a look at XLU. You can see that XLU has an even lower reading than both Google and GLD for its actual implied volatility number.
It's down at 19.69 or .1969. But looking at the chart, you can see that this level is relatively high, very high for XLU. It's still in the 77th percentile, so almost exactly where GLD was, except its actual ranking number is much lower.
You can see this implied volatility understanding of where volatility is relatively cheap or expensive gives us an edge in trading because what we want to do as traders are when implied volatility is high like it is here and here and here and also here in August.
We want to sell options or use strategies that are net sellers of options; credit spreads, iron condors strangles, straddles, etcetera.
When implied volatility is low like it was in June, pretty much all of July, September, December, the end of December heading into January, those are opportunities for us to buy option strategies or use options strategies that take advantage of the market possibly moving higher.
This concept of using implied volatility is so, so powerful and it’s important that you understand how it all works. It’s not about the actual number. It's about where it is in its historical range and rank.
Again, having an understanding of where implied volatility is about its past is critical to your ability to trade successfully long-term. We’ve said time and time again that in most cases, having the right strategy in the right market will trump or will beat out anybody who is directionally better than us.
You don't have to be good at stock picking. You just have to be good at understanding where volatility is and placing the right strategy for the right market. As always, I hope you guys enjoy this video.
This was a little bit more of an advanced tutorial, but hopefully, it gave you a really good understanding of the differences between these two and how you can apply them to your trading right now.
If you have any comments or questions, please ask them right below in the video lesson page. Until next time, happy trading!