Nicole Wachs gets crafty.
Have you ever been lost while traveling? Or used an out of date map? Or the address you entered on Mapquest gave you wrong directions? Not knowing where you are going can be quite frustrating. It's even worse when you don't even know where you are. Not understanding volatility can be a lot like getting lost. Analyzing it helps you build a map. Not only will this map show you where volatility has been, it may even help you figure out where it is going next. Nicole Wachs provides step by step instructions in how to create your own road map when it comes to this often confusing concept.
I noticed an excellent question in the forums recently. Potaire asked how does one define low, medium, or high Implied Volatility. Although I already posted a brief reply, I feel very strongly about this topic and thought it warranted a more robust discussion. Since Doc Maher has been walking us through a sample trade in ADI, I will use that as an example.
Let's look at a Volatility Chart for ADI (Quotes+Research > Volatility Charts).
Click here for a larger image. (Image 1)
The yellow lines are Implied Volatility (IV or vol); the white lines are Historical or Stock Volatility (HV). As Doc pointed out previously, the spikes in IV most likely coincide with past earnings announcements. As you can see, after the news or ‘cat' is out of the bag, IV returns to its previous levels. In the past I have stated that IV tends to move across time in a wave like manner - it oscillates. The chart above is a perfect illustration of this behavior. Because this is a somewhat common occurrence, it can be used to help create a volatility forecast. The trick is we need to know where we are now in the wave's cycle, so we need to draw our map. How do we do that? Let's move on to the next image.
Click here for a larger image. (Image 2)
In the image above, you can see that I have added two lines. The bottom line is drawn from identifying the low IV in June (green arrow). The top line connects the two high IVs in August and February (pink arrows). These lines have just defined the range of IV over the past year.
The analysis
If you are not into arts and crafts and drawing colored lines, we can go by the actual numbers. The next image was altered to get all of the data on the same page. To view the table at the bottom, just scroll down on the same page where you would access the chart. (Quotes+Research > Volatility Charts).
Click here for a larger image. (Image 3)
The 52 week high IV is 47.89.
The 52 week low IV is 23.65.
Subtracting these numbers will give us the range. 47.89 - 23.65 = 24.24
What does this tell us? Not much, except that the implied volatility has had a 24 point swing over a one year period. More can be extracted from this number, but that is not the main point of this post. Let's continue.
The next thing to do is to whip out your Ginsu knife. Or calculator - which ever you prefer. Take 24.24 and divide by 3. (Why 3? Because I said so. I want to keep this simple. You could also divide by 4, 10, or even 100.)
24.24 / 3 = 8.08
Let's round this down to 8.
Okay so now we know that the range is 24 points wide, and that if we divide this range into thirds, each part is 8 points wide. Now let's slice up the image with this information. How do we do that? We need to incorporate the boundaries we identified - the 52 week high and low.
If you would rather not eyeball where these new yellow lines go, you can use the following calculations.
Take the low of 23.65 and add 8 volatility points. 23.65 + 8 = 31.65
Take the high of 47.89 and subtract 8 volatility points. 47.89 - 8 = 39.89
Click here for a larger image. (Image 4)
Below are the labels for each third of the volatility range. Great! The preparation is done; our map is complete. Now what? Remember that I explained that IV oscillates? For those math people out there, another term is mean-reverting. That means that as the value reaches the extreme points of the range, the value tends to be drawn back to the center - or its mean. So what in the world does all of this have to do with trading options? Well I am glad you asked.
Click here for a larger image. (Image 5)
The Takeaway
The above diagram will help us to analyze or determine whether volatility is low, medium, or high. Here's the thought process: if IV was in the upper third, this would be considered HIGH implied volatility. If IV was in the lower third, this would be considered LOW implied volatility. If it's in the middle third, this would be considered average or medium volatility. Depending on where volatility is, this technique may help you to make a forecast about where it is going next. This is because if vol is in the upper third, there is a better chance that it will decrease rather than increase in the near future. If vol is in the lower third, it is more likely that it will increase instead of decrease. If vol is somewhere in the middle, in this case it will be more difficult to anticipate volatility's next move.
In addition, the forecast will help you to choose a strategy that performs well if your prediction is correct. But this is a discussion for another day.
The other big point here is that there is no average implied volatility across all stocks or options. Average is a relative term, and as such you need to look at each case with respect to the facts that surround it - meaning what is the customary high or low of volatility for that particular symbol. This also means that what may be a high number for one stock, may in fact be a low number for another stock. For RIMM, you can see that an IV of 45 would be considered pretty low, but this number would be really high for ADI.
Click here for a larger image. (Image 6)
Please keep in mind that this is not an exact method. Even though we are identifying the extremes, it is possible for volatility to go beyond them. Kindly exercise good judgment when making trading decisions based on volatility. This process is meant to be a guide, but you must make decisions based on your own risk parameters and financial goals.
So now that we have drawn our road maps, maybe someone in the Community can tell us which way we are headed?
How would you rate the current IV for ADI?
What is your IV forecast for ADI?
How would you rate the current IV for RIMM?
What is your IV forecast for RIMM?
I look forward to hearing your answers and reading your comments.
TradeKing Staff
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This comment and any market data included here were completed on 5/7/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Image taken from the original Ginsu TV Commercial. Sorry, Japanese Chef not included.
