Volatility in the Crosshairs: Aligning Volatility and Strategies Part 1

While the chart in figure 1 gives a quick snapshot of 3-years of implied Volatility, there is a way to observe volatility on a more granular level.  This can be done with implied volatility percentile rankings shown in figure 2.  Percentile rankings utilized the same data as in figure 1 but were just reformulated to allow a deeper dive into a “volatility gradient”.   Bear with me here as we draw an analogy.   Implied volatility percentile rankings work much like college entrance exams that many of us are familiar with.  If you took, for example, the SAT test, you received two scores: a raw score and a percentile ranking.  If you scored a 790 on the math section, you were in the 99^th percentile.  That is, you beat 99 percent of those that took the test and likely went on to a prestigious university.   If you scored a 300, you were in the 10^th percentile and would probably want to retake the exam as 90% of those taking the exam scored higher. 

Volatility percentile rankings work the same way.  We took the implied volatility numbers each day and ranked them using a percentile generator in excel.     Figure 2 shows the implied volatility percentile rankings for the E-mini S&P 500 options on futures.  The data was taken each day and we used three years of data (ending October 16 in this case). The implied vol is the ATM straddle using a 30-day expiry (constant maturity).

The highest implied volatility during this 3-year window was 31.64.
The 90^th percentile level was an implied vol of 17.29%
The 75^th percentile level was an implied vol of 13.79%
The 50^th percentile level was an implied vol of 10.56%
The 25^th percentile level was an implied vol of 8.81%
The 10^th percentile level was an implied vol of 7.59
The lowest implied vol during that three-year window was 6.50 which, in fact, is very close to the   at-time historic low of 6.40 % attained since the launch of the E-mini contract. So, let’s say todays implied volatility was calculated to be 7.59%.   This would put it at the 10^th percentile—i.e. 90 percent of the time implied volatility was higher.   Rising volatility helps long options positions.  Traders get long premium (straddles, strangles, etc.…) in anticipation of higher vol in the near term (the last column of figure two shows the ATM straddle in premium and dollar terms).

At the 10^th percentile the ATM straddle would cost the buyer 50.51 pts (or $2,525).  But the price of the same straddle at the 50^th percentile is a much higher 70.14 pts (or $3,500)—a substantial difference.  By comparing the current volatility rank to the relative level of volatility over time, the trader can discern the probability of higher/lower volatility—which could lead to better odds of trading success.  In subsequent installments of this series, we shall probe further and look at implied volatility percentile rankings in many of CME Group’s major product lines including equities, rates, currencies and commodities.   

For those inclined to sell options premium, the goal would be to do so in higher vol environments such as the 75-90^th percentile.   But remember, selling options carries unlimited risk.  Hence, your risk management capabilities must be spot on and your account large enough to withstand the added risk.

Most importantly, percentile rankings can help you manage risk.  If you are going to be wrong with an options purchase, better to be wrong buying premium in the 10^th percentile than in the 90^th percentile.  Just notice the difference in the premiums of the ATM straddle in figure two at the 10^th percentile and the 90^th percentile.  The straddle at the 90^th percentile is twice more than as expensive.  Being wrong in the 10^th percentile would cost you only half as much should you experience the maximum loss.