Volatility in the Crosshairs: Aligning Volatility and Strategies

On the other hand, Figure 2 shows a table with implied volatility percentile rankings. Both Figure 1 and 2 use the same data, just reformulated to allow a deeper dive into a volatility gradient. Implied volatility percentile rankings work much like the 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 99th percentile. That is, you beat 99% of those who took the test and likely went on to a prestigious university. If you scored a 300, you were in the 10th 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 from over the last three years, ending with July 16, 2018. The implied vol is the ATM straddle using a 30-day expiry (constant maturity).

*2815 straddle (ATM), 30 days to expiry

The highest implied volatility during this 3-year window was 34.03.

The 90th percentile level was an implied vol of 18.34%

The 75th percentile level was an implied vol of 13.8%

The 50th percentile level was an implied vol of 11.3%

The 25th percentile level was an implied vol of 9.03%

The 10th percentile level was an implied vol of 7.59%

The lowest implied vol during that three-year window was 6.5.

So, say today’s implied volatility was calculated to be 7.59%. This would put it at the 10th percentile—i.e. 92% of the time implied volatility was higher. Higher volatility helps long options positions. Traders get long premium (straddles, strangles, etc…) in anticipation of higher vol in the near future (the last column of Figure 2 shows the ATM straddle in premium terms).

At the 10th percentile the ATM straddle would cost the buyer 48.21. But the price of the same straddle at the 50th percentile is a much higher 72.06—a substantial difference.

For those inclined to sell options premium, the goal would be to do so in higher vol environments such as the 75-90th percentile. But remember, selling options carries unlimited risk. Hence, risk management capabilities must be spot on and the account  large enough to withstand the added risk. Most importantly, percentile rankings can help manage risk. If a mistake is to be made with an options purchase, better to be wrong buying premium in the 10th percentile than in the 90th percentile. Just notice the difference in the premiums of the ATM straddle in Figure 2 at the 10th percentile and the 90th percentile. The straddle at the  90th percentile is more than twice as expensive. Being wrong in the 10th percentile would cost significantly less in the case of maximum loss.

Repeating what we said earlier, buy low / sell high pertains to an option’s implied volatility too. The crux of these tables is to showcase that buying options premium in the lower percentile rankings and selling options premium in the higher percentile environments might lead to better results for the trader. Volatility percentile rankings can help the trader align the correct strategy for the correct volatility environment.

In the pages that follow, we have provided the volatility percentile rankings for many of CME Group’s core products. The data is for the three-year period ending July, 16, 2018.

Several years ago a broker and one of his larger clients witnessed the market treading water for months and volatility creeping lower and lower with each passing week. The client and broker decided to sell a large number of straddles in the S&P 500® futures to take advantage of the time decay inherent in straddle selling.

At that particular time, volatility was running at 7.1%. The lowest it had been in the last decade was 6.9%. In fact, at 7.1%, it was in the 2nd percentile. 98% of the time volatility is higher than 7.1% and when volatility heads higher, it has a negative impact on short straddles. Statistically speaking, the probability favored higher vol. But vol could remain low and the strategy would be profitable in that case. But probability is not working in your favor.

A week later the market plunged and volatility went from the 2nd percentile to the 90th in 5 trading days. Needless to say, the straddle would have lost substantial sums of money in a short period of time. The puts and calls exploded in premium terms. Volatility percentile rankings would have helped determine if this strategy had acceptable odds for success.

• Anyone can trade a straddle or strangle or any other options strategy from the long or short side. But doing the trade in the correct volatility environment will be a key determinant in success rates. A trader wants probability working for them, not against them.
• Buy low, sell high pertains to volatility levels too.
• Use volatility percentile rankings as a tool or gauge to screen for certain trade strategies. They can be used as a risk management tool as well.
• To short premium, consider doing so when volatility is high…above the 75 percentile. Remember, percentile rankings are only one tool. Just because volatility carries a low percentile rank, does not mean that it cannot go lower. High volatility can sometimes go higher as well.
• Moreover, even if you are fortunate enough to buy volatility in the lower percentile rankings, you still must deal with time decay issues and choosing the appropriate strike prices and strategy. Keep in mind that options are four dimensional instruments—   it is not only the up and down movement in the underlying that matters, but time to expiration as well as volatility. It is more work—more plates to keep spinning, but the additional strategies available to options traders are worth the  effort.

Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs)         within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible          to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion           of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.

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The information within this communication has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this communication are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and superseded by official CME, CBOT, NYMEX and COMEX rules. Current rules should be consulted in all cases concerning contract specifications.

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