Implied Volatility: How Low Is Low (And How High Is High)?
A member recently e-mailed: “I often hear people say, ‘Buy when the volatility is low and sell when it is high.’ Does this really mean to get into positions (either long or short) when volatility is low and get out when it’s high?”
No, it’s not that simple. “Volatility is low” really means “the implied volatility is low.” Implied volatility (IV) is to some extent “mean reverting;” that is, it tends to move back from extremes toward its average value.
If the implied volatility is low, option premiums are relatively low and you gain an extra edge if you are long premium, because when the IV returns to “normal,” the premiums will rise. Of course, the question is, what is low?
Constructing implied volatility bands
| Take a moving average of the IV, roughly the length of the time remaining until expiration |
You can look at implied volatility charts going back years if you have the data and the software. However, you generally only want to know what probably will happen in the time frame of your holding period, which is at most the time until expiration of the option.
To do this, you can look at the moving average of the IV with a length of roughly the time remaining until expiration. Next, you measure the standard deviation (SD) of the IV and construct a two-SD Bollinger Band, which will give you an idea of how the IV oscillates over the time period of interest to you.
| Next, measure the standard deviation (SD) of the IV and construct a two-SD Bollinger Band |
“Low” now means in the lower part of the Bollinger Band; “high” means in the upper part. When the IV is low (you can set the cutoffs yourself), you are generally better off buying premium; when it is high, you are generally better off selling premium.
These are general guidelines. You can refine them yourself considerably, taking into account such things as trends and seasonal variations. You can even devise rules to follow, noticing that the higher and lower you place your cutoffs, the less often you will have high (selling) and low (buying) opportunities. This is a general rule in trading and investing: The better the opportunity, the rarer it is.