Welcome to yet another article in the segment of advanced options trading. As we had discussed in our previous articles about the open interest, call and put open interest, put-call ratio, and as well as max pain theory. I hope you have read it at once. Now, moving on, we are going to learn about the implied volatility percentile.
IVP or implied volatility percentile is an indicator that can give you a lot of sense that what is going to happen in an index or a share of the market as a whole because IVP is a thermometer that gives you whether the market is hot or cold. I am going to discuss IVP or implied volatility percentile for retail traders specially to make awareness to give them a kind of feedback that how they should approach the options market because as I understand that the future and options are a segment where most of the retail traders make losses because they just get inside without learning and any understanding of future and options.
Let’s recap and see firstly, what is this IV or implied volatility? Implied volatility means that market can go in any direction, either upward or downward. It is impacted by many factors like supply and demand, fear, the market sentiment, or the actions of the company. It goes up when the market is bearish, and investors’ market sentiment is low. The opposite occurs when the market is bullish; IV reduces drastically.
Whether used to transform a portfolio, generate income, or leverage stocks, options are very much my favorite choice and have some advantages over other investment tools. But its price is highly volatile and made a difference by implied volatility. You can get a steady income return with future and options and that is very much possible but you have to know all operations of options. Without knowing and if you can be getting into feet, then options can be very dangerous. Implied volatility percentile tells you exactly whether a stock is highly volatile or not or whether an index is highly volatile or not.
As you know that Options prices have two main parts – time value and intrinsic value. The intrinsic value is the price difference in the market or spot price. Suppose you own an option for Rs 100, which has a current market price of Rs 110. You can then buy it at a lower cost and sell it for a higher price to realize a profit. The intrinsic value of the option is then Rs (110-100) or Rs 10.
If you go and if you watch the shares high IV then if the IVP is showing you the 65% or 70% and if you can get a feeling that ok whether this stock or index is highly volatile and what happens when the stock becomes highly volatile and nonstop, then its premium increases. So, at that time, you have to sell options and you don't have to buy them.
Now, one of the questions which always retreat an options trader is: is implied volatility very high or very low and how do you understand if an IV is very high or very low? 25% is a high IV for an Index like NIFTY or BSE, 30% is low for a large-cap company, and even 80 is not very high for a much volatile small-cap company. So how can you know if an IV is very high enough to sell or very low enough to buy?
Let’s understand the term IVP. IV percentile (IVP) is a relative estimate of Implied Volatility that contrasts the current IV of a stock to its Implied Volatility in the past. In simple words, IVP determines you the percentage of time that the IV in the past has been lower than the current IV. It is a percentile number, so it changes between 0 and 100%. A high IVP number, mainly above 80%, tells us that IV is high, and a low IVP, mainly below 20%, says that IV is low.
Remember that there is not a perfect thing in trading, and the IV percentile is not a magic number to analyses options contracts. It has its disadvantages. Long/short volatility trading works effectively when the volatility tends to change to its mean. That is when extremely low or high IV conditions are not determined and the IV tends to move towards its mean after times of utmost high/low IV.
However, there can be some time of enlargement and determined high/low volatility. In these situations, long/short volatility strategies may not give you the best result. Also, sometimes these strategies take time to become beneficial — the up/down in volatility may take longer than expected, and the effects of theta and delta may reverse the profits from Vega. Remember that IV goes up and down just like prices and is an almost extremely difficult task to predict.
So, in conclusion, the IV percentile is a useful indicator to find out very fast whether a specific stock’s IV is high or low. This, in turn, can give us a hint whether a debit or credit strategy is the wise choice in the situation. However, just like anything else in trading, it is not something to observe and follow blindly. All other factors must be taken care of before entering into a position.