If you are looking to become a Stock Options trader, or if you already are, you should know about Implied Volatility (IV). Imagine making the right trade and getting an absurd amount of income because you knew the right time to trade.
According to tastytrade, implied volatility rank is a metric that predicts the likelihood of the Stock Option prices changing. However, the IV doesn’t depend on past data, and what’s more, it only uses Option prices as the only fundamental factor. Implied Volatility will enable it to do just that.
This is a significant discrepancy and especially for a serious trader who is looking to make a kill. Incorporating other fundamental factors related to the stock market might better place you in a suitable space to invest in Stock Options.
What is IV Rank?
Now that most of you are familiar with IV, you will appreciate a little extra knowledge that might buy you that dream house you’ve always wanted. The Implied Volatility Rank is a great way to start. It refers to the current IV compared to the IV of the same Stock Option for the past 12 months.
You might be thinking, how is IV Rank related to historical volatility or statistical volatility? It is undoubtedly true that statistical volatility and IV Rank rely on past data to arrive at their predictions.
Nevertheless, IV Rank is purely determined from the IV of the past 12 months, while statistical volatility is determined by the prices of the Stock Options in the periodic past.
IV Rank is a measure of the probability of the option price deviation compared to previous probabilities made on the same Stock Option in the past year. It compares explicitly past probabilities to derive a much precise price deviation index.
It is crucial to understand how the previous IVs were distributed to get an appropriate perspective of where the current IV lies in relation to them.
Calculating the IV Rank
Perhaps if you knew how to determine the IV Rank, you would better use and apply this concept and make better returns when investing in a Stock Option.
As we had earlier established, the IV Rank compares the data from past IV within the prior 12 months. To calculate the IV Rank, you would have to gather all the IVs and arrange them in one data set for comparison.
Please note the highest and lowest values as they are the key factors when calculating the IV Rank. This is because the IV Rank measures how high or high low the current IV is compared to other IVs. For example:
Take an instance where there are eight IVs of a Stock Option calculated from the past 12 months as follows: 10, 18, 30, 26, 23, 16, 27, and 25. You can start by arranging the data set in an ascending or descending order.
In ascending order – 10, 16, 18, 23, 25, 26, 27, 30
In descending order – 30, 27, 26, 25, 23, 18, 16, 10
You can see the highest and lowest IVs from the arrangement. Alternatively, you can believe in yourself and identify the original dataset’s highest and lowest IV numbers. Still, you better be careful not to make a mistake, or your calculations will be inaccurate.
Now let’s get to it:
To calculate the IV Rank, you have to have the current IV on the Stock Option. Using our data set, with a current IV of 10, the IV rank would be zero because 10 is the lowest in the 12-month IV data set. It also ranges from 0 – 100, with zero being the minimum value and 100 the highest value.
Similarly, if your current IV is 30, the IV Rank would be 100 as 30 is the highest IV value in the given data set. Assuming that the current IV is 20, the IV Rank would be 50 as an IV value of 20 is the middle figure between the lowest and highest IV values in the data set.
The IV Rank can also be calculated as a percentile. The percentile places the current IV on a percentage scale from the lowest value. Ideally, an IV Rank of 50 places you at the best probability for you to trade or invest in your Stock Option.
Why IV Rank is Important
The IV is an essential metric in determining the volatility of a Stock Option, but it can also be misleading. If you take, for instance, that the IV of a Stock Option to be 30, it may seem like a high IV and a good prospect for trading.
Nevertheless, using the IV Rank measure and taking into account the history of the IV of the Stock Option, you might find the IV Rank value to be 90%. This means that despite the current IV being high, the high IV Rank also shows that it is among the high IVs and thus might not be as promising as you would have initially believed.
Using both the IV and the IV Rank enables you to better determine the appropriate volatility of a Stock Option before trading or investing.
As a trader, you should be ready to take advantage of unfolding opportunities. As a buyer, you should invest in buying Stock Options when the implied volatility is low. Alternatively, as a seller, you should be ready to sell the Stock Option when the Implied Volatility is high.
This is simply because when the IV is high, Stock Option prices are higher and lower when the IV is low. Even so, the Implied Volatility Rank will give you a trading edge as you would be able to tell which IVs are flukes.