Volatility levels are widely used by traders when making a decision to enter or exit a position. Understanding the differences between the various metrics of volatility can help gauge option pricing, and can be essential in your efforts to be more consistently profitable in your trading.

Implied Volatility Percentile (IVP) or Implied Volatility Rank (IVR) are two tools which can be used to track historical volatility. Using these tools will show you where the current IV number is in relationship to what volatility has been in the past.

When you learn to use the relationship of the current implied volatility and compare it to historical volatility by using either IV percentile (IVP) or IV rank (IVR), you will have an edge in your trading for many strategies. When you compare IV to IVP or IVR, it is important to use IVP consistently or IVR consistently. Comparing the current IV to both IVP and IVR can lead to confusion. It is important to either use IVP or IVR. Using IVP one time and IVR the next time is not recommended. Stay consistent.

When you look at the implied volatility (IV) of an option, it is reflecting the current IV. It is important to understand the relationship of the current volatility to the past historical volatility. This will help to determine what type of trading strategy to use when you enter a trade.

The can give your trading an edge.

To start, let's review the basics of Historical and Implied Volatility

**What is the definition of Volatility?**

**Historical Volatility**is a measure of past performance. Because it allows for a more long-term assessment of risk, historical volatility is widely used by traders and market analysts in the creation of investing strategies. Historical volatility is also referred to as realized or statistical volatility. For the purpose of this article, I am using current IV percentile as historical/statistical IV. IV Rank is another method to determine historical IV which you will also learn about in this article.**Implied Volatility (IV)**is the estimated volatility of a particular stock/index. IV is a calculation which reflects the current volatility. In general, implied volatility increases when the market is bearish, when investors believe that the underlying price will decline over time. Generally, implied volatility decreases in a bullish market, when investors believe the underlying price will rise over time. If there is a sharp move upward in price, there are instances when short term volatility may increase.

**How can Implied Volatility affect Options Traders?**

**Implied volatility is one of the key factors in the pricing of options.**Options give you the opportunity to purchase or sell an underlying at a specific price during a pre-determined period of time. The higher the implied volatility, the more premium the option will have. The less the implied volatility, the less the option's premium.**Knowing the relationship between implied volatility (IV) and current IV percentile**can allow you to determine if an option is more inexpensive or expensive…**Implied volatility has the biggest effect on the amount of extrinsic value in the price of an option.**When IV increases, the extrinsic value of both calls and puts increases. This makes the call and put option prices more expensive. When IV decreases, the extrinsic value of both calls and puts decreases. This makes the option prices less expensive. If you would like to read more about the intrinsic and extrinsic value of options, here is an article published on August 17, 2018: Intrinsic and Extrinsic Value of Options

**An option's value is determined by the following components:**

- Stock Price
- Strike Price
- Time to Expiration
- Volatility
- Interest Rates
- Dividends

Five of these components are easy to determine. They are basically fixed. The one which is unknown is volatility. As volatility goes up or down, it can reflect significant changes in the price of an option. Two of the most important components of an option's price are volatility and time to expiration. These two components can greatly affect your overall profit and loss. When you purchase an option, it is not enough to be right on market direction. You also have to be aware of time decay, volatility, and the relationship of current IV to its historical IV.

** What is IV Percentile?**

Implied Volatility Percentile (IVP) can provide traders with an additional metric to help gauge the pricing of options. IVP will tell you the percentage of days over the past year that implied volatility traded below the current level.

To explain IVP, let's start by looking at the current implied volatility using the S & P 500 Index as an example.

The one year chart of SPX is shown below, showing the current implied volatility of 21.67%.

Figure A. One Year SPX Chart indicating current Implied Volatility

Below is a screenshot taken from the Think or Swim option chain.

Figure B. Today's Options Statistics from Think or Swim

One way to find Current IV and IV percentile on the Think or Swim platform is to scroll down to the bottom of the option chain and look for Today's Options Statistics. It shows the Implied Volatility of 21.67%, as well as the Current IV percentile at 34%**. **

The current IV Percentile is calculated by taking the number of trading days the IV of SPX was below its current level and dividing it by 252 (the number of trading days in a year). The current IV Percentile in this example is 34%.

Using this example with IVP at 34%, the understanding can be that implied volatility of SPX traded below the current implied volatility of 21.67% for 34% of the past year, or about one-third of the year. This indicates that SPX IV was below 21.67% for about one third of the year. For two-thirds of the year, the implied volatility was above the current level of 21.67%.

This means that the current IV of SPX in relationship to its historical past is in the lower one third region. Therefore, option prices will be less expensive or “rich” than if the current implied volatility was at higher percentage.

**How do you know if the IV of an option is high or low in relationship to itself?**

**Here is an example:**

Stock ABC ‘s current price is currently trading at 50. The implied volatility of the stock is 20.0%, and the IV percentile is at 80%. Looking at an implied volatility of 20.0% you, would probably think the current IV was on the lower side.

Look at the Implied Volatilty Percentile. It is at 80%. What does this mean to you? It means over the past year 80% of the time ABC’s current IV was below 20.0%. This indicates ABC options are probably costly due to the current implied volatility of 20.0% relationship to the implied volatility percentile of 80.0%.

Remember, the current IV of 20.0% was lower 80% of the time over the last year. This shows the current IV to be high. This will make options more expensive or “rich”.

**Implied Volatility Rank is yet another volatility metric that many traders take into account when making their trading decisions…**

Implied Volatility Rank (IVR) can tell you whether the current implied volatility is high or low based on the IV over the past year. It is an average of the highest high and lowest low volatility for the past 52 weeks. Other time periods can be used such as 30 days with some trading platforms.

Let's use the same SPX example for one year to calculate IVR. The 52 week IV high was .468, and the 52 week IV low was .088. The formula used for a one-year IV rank is as follows:

Figure D. IV Rank Formula (photo courtesy of www.projectoption.com)

To calculate the one year IVR, look at the options statistics in Figure 2.

With SPX IV currently at 21.67%, the IV Rank would be calculated as follows:

Current IV (.2167) minus 1-Year IV Low (.088) = .1287

1-Year IV High (.468) minus 1-Year IV Low (.088) = .38

.1287 divided by .38 = IV Rank of .338 or 33.8%.

This IV Rank of 33.8% indicates that the current IV and the low IV is only 33.8% of the entire IV range over the past year. This means the current IV is closer to the low end of historical levels of implied volatility.

At the extreme levels, an IV rank of 0% means that the current IV is at the lowest point of the one-year range, and an IV rank of 100% means the current IV is at the highest point of the one-year range.

**How can you take advantage of the relationship between current Implied Volatility and IV Percentile or IV Rank?**

You can base the type of trade you place using Implied Volatility, IV Percentile and IV Rank. As you know, there are risks and rewards with every type of trade. A few strategies for consideration using high and low volatility levels are:

**High Volatility Could Indicate Opportunities to Sell**

You expect volatility to decrease, thus the option you sell could decrease in price, making it profitable.

**Credit spreads.**When you sell a credit spread, you will receive a higher credit when volatility is high.**Iron Condor.**When you sell an Iron Condor, you will also receive a higher credit when volatility is high.- When you buy a
**Butterfly**in a high volatility environment, your position will benefit as volatility drifts down, as long as the underlying price stays close to your short strike.

**Low Volatility Could Indicate Opportunities to Buy**

You expect volatility to rise, therefore, the option you buy could become worth more.

**Long put or put debit spread.**This trade can allow you to lower your cost and benefit from a spike in volatility.**Long Calendar spread.**This trade could benefit from the back month volatility increasing while the front month options decay.**Iron Condor.**The Iron Condor tends to perform better in higher volatility markets, but can still do well in lower volatility markets.

When you base your trade strategy on the relationships between Implied Volatility, and IV Percentile, and IV Rank, it does not guarantee that your trade will be profitable. However, it does give you a tool to use for your trade entries and exits so volatility can have a chance to work in your favor.

Do you have a trading method using volatility you would like to share? Please feel free to comment below.

]]>A calendar spread is a strategy often referred to as a time spread. A calendar is a method which could benefit from the time decay of an option and changes in implied volatility.

For the most part a calendar concentrates on the movement of time and volatility more than the movement of the underlying asset. For this reason a calendar spread can be used for either stagnant or large movements in the underlying.

Like any strategy the calendar has advantages as well as disadvantages. The risk can be quite limited for the buyer; the seller can have a larger risk. To contain some of the risk, a seller can act on the position at the expiration of the near term option. There are also strategies which can be used to lessen the seller’s risk.

One of the advantages of the calendar strategy is the position can be entered with less of an investment than purchasing the underlying asset.

**How is a Calendar Spread created?**

A Calendar spread is constructed by purchasing one option and the sale of another option in different expiration cycles in a one to one ratio. Both options will have the same strike price. The calendar can be created by using either two puts or two calls. The longer out in time option has more time value and will cost more than the closer in time option.

**How to construct a long Calendar…**

If you think the volatility is at a low level, you can buy a long calendar. To create a long calendar, you would purchase one option with an expiration further out in time and sell one option with expiration closer in time. As an example, you would buy a February 50 Call option and Sell a January 50 Call option. Another example, would be to buy February 50 Put option and sell a January 50 put option.

Figure A. Long Calendar Risk Graph from Think or Swim

As you can see in Figure A, the strike price of 50 is at the center of the risk graph. The highest profit potential is at the strike price.

**How you could profit from the long calendar spread…**

You can profit from a long calendar spread as time progresses and the price of the underlying stays favorable. The shorter term expiration will decay at a faster rate than the longer term position.

If the volatility increases the further out in time option will increase faster than the closer in time option. This will tend to increase the value of the calendar spread.

If you enter the calendar spread either in-the-money or out-of-the money and the price of the underlying moves towards the strike price, the position will gain in value.

**How you could lose from a long calendar spread… **

A decrease in implied volatility will decrease with the farther out in time option more quickly than it will decrease the value of the closer in time option. This will cause the position to lose value.

If the price of the underlying asset moves away from the calendar spread strike price, the calendar spread will decrease in value.

**How to construct a short Calendar Spread…**

If you have the assumption volatility is at high levels, you can create a short calendar. To create a short calendar, you would sell the farther out in time option and buy the nearer term option. For instance you would sell a February 50 Call option and buy a January 50 Call option.

Figure B. Short Calendar Risk Graph from Think or Swim

As shown in Figure B, the short calendar profits more as the underlying moves away from the center strike of 50.

*A word of caution concerning short calendar spreads. Shorting the longer dated option and buying the shorter dated option can be risky. The shorter dated option will expire before the longer dated option. This could lead to the seller of the longer dated option being naked that longer dated option. Therefore, the brokerage will most probably margin your account as though you are short the naked option. *

**How you could profit from a short calendar spread …**

If implied volatility decreases, the further out in time option which was sold will tend to lose money more quickly than the closer in time option which was bought. This is due to the higher Vega in the further out in time option. This will tend to create an increase in value to the seller of the calendar spread.

If the underlying asset moves up or down, away from the strike price of the calendar spread which was sold in either direction, it will tend to increase in value for the seller of the calendar spread, as long as the time decay of the option does not outdo the movement of the price of the underlying.

**How you could lose from a short calendar spread …**

As time passes it will usually negatively affect the seller of a calendar spread. This is due to the nearer term option, which is the long option for the seller, decaying at a more rapid pace than the farther out in time option, which the seller of the calendar spread is short.

If implied volatility increases it will also affect the seller of the calendar spread negatively. When the volatility increases the longer term option which was sold increases in value more quickly than nearer term option which the seller is long due to the longer term options higher vega.

**At-the-Money vs. Out-of-the-money and In-the-money options… **

Many times calendar spreads are entered at-the-money due to at-the-money options having the greatest amount of extrinsic value. The extrinsic value of an option will decay as the option gets closer and closer to expiration. This can be beneficial for a calendar spread because the strategy is looking for time decay.

There are other calendar strategies which can be constructed using out-of-the-money and in-the-money options. It is your choice.

The decay rate of the option with the same strike price, which has a longer expiration date will be slower to erode than the decay rate of the option which is closer to expiration. This applies to an in-the-money option, out-of-the money option or at-the-money option.

**Gamma’s Effect on the Calendar Spread…**

Gamma can be defined as the rate of change of the option’s delta as it relates to the movement in the price of the underlying. It can be thought of as the delta of the delta.

Gamma tends to be highest with at-the-money options in the nearer term expiration. Gamma will tend to decrease the further the price of the underlying moves away from the at-the-money strike and as the expiration date moves further out in time.

The nearer term option expiration will move more quickly due to its’ gamma being higher.

**How Does Volatility Influence a Calendar Spread?**

It is important to monitor the change in volatility when using the calendar spread strategy.

The volatility of an option is measured by vega. Vega is an approximate measurement of how much an options price will tend to change with a one point move in implied volatility.

Vega is shown in dollars for a one tick move or change in volatility. Let's say an option is valued at $2.00 and has 45 implied volatility with a vega of .05. Then the volatility moves up one tick to 46. The option would now have an approximate value of $2.10.

This is calculated by multiplying .05 times 2.00 which equals .10 or 10 cents. Adding the .10 to the original value of the option which was $2.00 equals $2.10.

**Key points about vega …**

- The price of an option will change as volatility increases or decreases
**Vega will tend to decrease with shorter dated expiration options**- Vega will tend to increase with longer dated expiration options
**Vega tends to be greatest with at-the-money options**- Vega applies to the strike price both calls and puts
**Vega will tend to increase when volatility increases**- Vega will tend to decrease as volatility decreases

**Wrapping up the Calendar Spread…. **

- Use two call options or two put options
**Use the identical strike price for both of the options**- Select different expiration periods for each option
**Create a one-to-one ratio**- Any two expiration periods can be used to create the calendar spread.

Usually, the calendar spread benefits when the price of the underlying is not moving too much and stays within a range.

If you have limited capital, the long calendar spread offers limited risk when entered as a debit. The risk is defined to the debit paid for the calendar.

You can use the calendar spread when volatility changes are expected.

As a seller of a calendar spread, you can take on potentially greater risk.

When the underlying price moves away from the calendar strike price, the buyer of a calendar will tend to lose money.

When the underlying price moves away from the calendar strike price, the seller of a calendar could increase profits as long as time decay does not surpass the movement of the underlying’s price.

If you have experience trading calendars, either long or short, and would like to share with the community, feel free to comment below.

Are you new to trading looking for mentoring, or an educational trade alert service? Or, are you a veteran seeking a trading group where you can interact with like-minded traders who share their experiences? Look no more. Join Aeromir today!

]]>The value of the SKEW Index rises with the tail risk of the S & P 500 Index. When there is no tail risk, SKEW is equal to 100. When SKEW is close to 100, probabilities of a sharp market move remains small. As the probability of a major market move increases, the SKEW index rises.

The mathematical definition of “standard deviation” is a measure of the dispersion of a set of data from its mean. The more the data is spread apart, the higher the deviation.

These standard deviations are important to options traders because they give definitive metrics which can be used to gauge the probability of a successful trade. Of course, there is no indication of the direction of a potential move; you as a trader can use your own technical expertise and chart analysis in conjunction with the standard deviation metrics. It is also worth mentioning that no trade can have a 100% probability of success. Even trades with boundaries of profitability of three standard deviations have the small but real probability of moving outside the predicted range of movement.

Represented by a bell curve, the graph below illustrates standard deviation and a normal distribution curve:

Figure A. Normal Distribution Graph (Image courtesy of Wikipedia.org)

If the data points in the distribution graph are all near the mean (center of the graph), then the standard deviation is close to zero. The farther away the data points are from the mean, the higher the standard deviation. The bell curve in Figure A is a normal distribution, and demonstrates that among a certain number of samples, there is normal outcome. In options trading, these normal outcomes can be used as a tool.

Breaking this outcome into percentages:

• +1/-1 standard deviation covers 68.2% of occurrences

• +2/-2 standard deviation covers 95.4% of occurrences

• +3/-3 standard deviation covers 99.6% of occurrences

Now, compare the normal distribution graph to ones that are skewed (to the left or the right). The chart below illustrates a normal distribution graph, as well as skewed graphs.

Figure B. Distribution Curves (image courtesy of assetinsights.net)

In Figure B, the Positive Skewness (curve on left) has a longer tail to the right, which indicates more tendency of upside risk. The Negative Skewness (curve on right) has a longer tail to the left, which indicates more tendency of downside risk.

**How is the SKEW Index calculated?
**

SKEW is calculated from the prices of S & P 500 options using a similar type of algorithm as that which is used to calculate the VIX, which is the CBOE Volatility Index. The mathematical calculation of SKEW can be found here: SKEW Index calculation

The SKEW Index typically ranges from 100 to 150, with a historical average of approximately 115. The higher the SKEW index rating, the higher the perceived tail risk and chance of a significant move.

Below is a 3 year, weekly chart of the SKEW Index from Think or Swim

Figure C. 3 year weekly SKEW Chart

The 20 period moving average is showing a value of 138.45 in Figure C above. The current SKEW value is 144.49. Since the SKEW's historical average value is approximately 115, the current SKEW of 144.49 is higher than normal. A trader who is fearful of increasing volatility may want to be cautious.

**How can traders interpret the SKEW Index?
**

While the SKEW index itself cannot be traded, investors may use it to help determining market risk. In general, the SKEW index rises to higher levels as investors become more fearful of a major, unexpected selloff of a large magnitude – a “black swan” event.

As the slope of implied volatility rises, the SKEW Index tends to rise. This may indicate an increase in the probabilities that a major market-moving event is forthcoming. It doesn’t, however, necessarily mean it will happen.

By monitoring the SKEW as it increases over 100, traders may choose to hedge their portfolios, add to current hedges, etc. As with any technical indicator, the SKEW index should be used in conjunction with other technical analysis such as support and resistance, volume, etc.

**Is the SKEW Index related to the VIX?**

The SKEW and VIX indexes are different from each other; yet complementary in terms of measuring the risk of the returns of the S & P 500 over a 30-day period. The VIX is a fairly close representation of the standard deviation of those returns, but this sometimes is not enough to measure the true risk because over time the distribution of the S & P 500 returns exceeds one standard deviation.

The SKEW index describes the tail risk of the distribution; it is a measure of the S & P 500 returns that are greater than two or three standard deviations below (or above) the mean.

Below is a one year daily chart, showing both VIX and SKEW.

Figure D. VIX/SKEW 1 year Daily Chart

Figure D above shows the correlation of SKEW and the VIX. From late December through the middle of January the VIX was hovering around 10 (right axis). At the same time, the SKEW index was in the 120’s to 130’s (black line/left axis). During this period, SPX was continuing to move up in price, as you can see in Figure E below. A trader could interpret this to be an indication of a possible large move in price because SKEW was in the 120 to 130 range. The VIX reached a high of 50.3 on February 6th 2018; at the same time SKEW was around 133.

As with any indicator, signals can be tricky. As an example, please take note of the low price of SKEW (117.99) on January 26, 2018. At the same time the VIX was trading around 10. The SKEW had moved down to 117.99 from its’ previous higher levels, indicating less of a risk of a major market move. This occurred just before the price of SPX started to decline dramatically. A trader may interpret this as a mixed signal.

Figure E. SPX 1 Year Daily Chart

Here’s a good video to watch by Alessio Rastani, which shows other scenarios of the SPX/VIX/SKEW correlation, to forecast a potential large move in the market.

Go to…How to Predict a Fall in the Stock Market

**In summary …
**

A trader cannot use the SKEW Index itself as an instrument to place a trade. What it can do for traders is to measure current market risk. The SKEW index for the most part ranges from 100 to 150. The SKEW Index usually rises in market uncertainty.

The SKEW Index is one more tool for traders to have available to them to make a more informed decision on their positions and portfolio.

Any one indicator you as a trader choose to incorporate into your technical analysis is not going to make you money unless you use it consistently, and this holds true for the SKEW index.

Following the SKEW index along with its relationship to the VIX, as well as price action, may give traders an insight on overall market risk.

If you have found that monitoring the SKEW index has been helpful in your trading and would like to share, feel free to comment below.

Are you looking for a mentoring program, educational alert service, or a group of like-minded traders to share both positive and negative trade experiences? Look no more, join today!

You will find a wide variety of educational services in addition to the trading groups that meet on a regular basis to exchange their trades and ideas.

]]>