Options traders are in a unique position. Regardless of whether the market soars or plummets, they can make a profit. To do so, though, they have to pay extremely close attention to volatility—the volatility of the market as a whole, as well as the volatility of the individual securities that they’re interested in trading.
Volatility refers to the range of returns for a financial instrument over a fixed period of time. Past volatility can be measured; future volatility can only be speculated. Because options trading is about making informed bets about will happen in the future, options traders pay the closest attention to future volatility, called implied volatility.
First, let’s define volatility in the context of financial markets. Then, we’ll differentiate between historical and implied volatility and discuss how market volatility is measured. Last, we’ll review the Rule of 16 and what it means for the options trader.
A Brief Introduction to Volatility
Volatility can be measured at different scales, from the volatility of an individual equity, say, to the volatility of the market as a whole. The volatility of an entire market, such as the United States stock market, is called market volatility.
A financial instrument, such as an equity or bond, is said to have low volatility if its range of returns over time is small. Likewise, a financial instrument is said to have high volatility if its range of returns is large. It’s a rule of thumb that the higher the volatility of an instrument, the riskier it is to purchase it.
To use terminology from statistics, the range of a security’s returns is called dispersion. In the context of financial volatility, the term standard deviation is the measure of how much the returns disperse from the average return. It is calculated by taking the square root of the variance between each return.
Lost? Don’t worry if you didn’t take statistics in high school. There are online calculators that will do the math for you. Just remember that volatile financial instruments, that move dramatically up and down, have a high standard deviation.
The Difference between Historical and Implied Volatility
The past volatility of a financial instrument is called historical volatility (HV). Why does historical volatility matter? Although it is not a failsafe predictor of the future, historical volatility can provide useful information about how a stock might perform in the days and weeks ahead.
For example, ABC Corp. and XYZ Inc. are each trading at $100 per share on August 1st. While ABC Corp. has been steadily trading at anywhere from $95 to $105 per share throughout July, XYZ Inc.’s share prices have swung wildly, from $50 at the beginning of July to $125 toward the end of the month. ABC, with its minimal price swings, has low historic volatility. XYZ, on the other hand, has high historical volatility. A quick look at ABC’s and XYZ’s historical volatility throughout the month of July tells a clear story: purchasing shares of ABC is less risky than purchasing shares of XYZ.
While historical volatility describes what happened in the past, implied volatility (IV), or expected volatility, attempts to explain the future. Implied volatility is derived from traders’ best guesses about a stock’s future performance. Note that implied volatility does not predict the future. Still, it does provide a snapshot of what traders believe will happen.
Implied volatility is often determined by assessing changes in the price of options. Numerous factors go into the calculation of options prices. According to one of the most popular models for pricing options, the Black-Scholes Model, these factors include the share price of the underlying financial instrument, the strike price, the time until the strike date (also called the expiration date), and the type of option (that is, whether it is a call or put), among other factors. In general, if the price of options for a particular instrument, say ABC Corp., begins to rise, then that means that traders suspect that ABC will likely experience high volatility—in any direction. The opposite is true, too. If options prices are low for ABC, it means that traders have a hunch that its volatility will be modest.
What does this mean in practice for options traders? As always, options buyers and options sellers have diametrically opposed strategies. In most cases, the buyer of the option is hoping for high volatility while the options seller, also called the writer, is hoping for low volatility. Put another way; the buyer of the option is betting that the realized volatility (a way to speak about future historical volatility) will be higher than the implied volatility; the options seller is betting on the opposite.
How Market Volatility Is Measured
Investors of all stripes (not just options traders) look to the Chicago Board Options Exchange (CBOE) Volatility Index to gain a sense of the United States stock market as a whole. The Volatility Index referred to as the VIX (and sometimes as the Fear Gauge or Fear Index), is a forward-looking measure of implied volatility. It reflects traders’ predictions about how the S&P 500 index will perform over the next 30 days. The VIX measures the implied volatility of the S&P 500, as opposed to some other index because its performance is thought to closely track the performance of the United States stock market as a whole. If stock prices are falling, it is to be expected that the VIX is rising.
The VIX level, or number, is derived from the prices of S&P 500 index options. Sometimes it is expressed just as a number and other times as a percentage; regardless of how it is presented, it should be thought of as a percentage. In early January 2020, before the markets began to seriously worry about the spread of COVID-19, the VIX level hovered at 12 and 13. A VIX level in that range indicates that traders anticipate a month ahead with minimal volatility. As COVID-19 began to spread increasingly rapidly across the globe, the VIX level steadily climbed, topping off at the staggering 82.69 on March 16, 2020, two points above the VIX level in November 2008, the depth of the Great Recession. An 82.69 VIX level indicated that traders expected the stock market to be extremely volatile for the next 30 days.
Options traders pay close attention to the movements of the VIX before buying or selling options, as the VIX level reveals options traders’ feelings about the market’s future at a specific moment in time. It’s valuable information. At the same time, the savvy options trader will recall that the VIX is just a reflection of traders’ educated conjectures about the future, conjectures that may be right or maybe wrong.
It’s also possible to calculate the implied volatility of a specific security. There are a number of ways to calculate it; a popular method is the Black-Scholes Model, mentioned above.
The Rule of 16
The VIX level, along with the volatility of individual instruments, is presented in an annualized format. But an annualized number—that is, the volatility for an entire year—is not particularly useful for options traders who are dealing with options that will expire soon, perhaps in few weeks or a few months. Options traders need to understand the near-term volatility of shares they’re trading.
There is a fairly easy way to calculate daily volatility: divide the annualized implied volatility level by the square root of the number of trading days per year. Although there are 365 days in a year, there are only about 252 days when trading can take place, due to holidays and weekends. The square root of 252 is approximately 15.87, which traders round up to 16. Hence, the Rule of 16.
The equation for daily implied volatility (IV) looks like this: annualized IV ÷ 16 = daily IV. It’s also possible to calculate the annualized implied volatility from the daily implied volatility. Simply multiply the daily implied volatility by 16, or daily IV x 16 = annualized IV. If you can’t remember the last time you quickly multiplied or divided by the number 16, then you’re probably not an options trader.
Let’s say that you’re trying to understand daily implied volatility for the next month. The VIX level is 20. Because the VIX level is annualized, you’ll need to divide it by 16 to acquire daily implied volatility; 20 divided by 16 equals 1.25. This means that you can expect the market have a 1.25% daily volatility. The same equation applies when calculating the implied daily volatility of an individual security.
Of course, it’s important to remember that implied volatility is just that—implied. The best models in the world can’t predict the market’s future.