Historical and implied volatility are two very important concepts that every options trader should be familiar with. In fact, if you take a closer look at these two, you will be able to identify an inefficiency that can create an edge for certain option traders.
In this article, I will explain what the differences between historical volatility vs implied volatility are, how volatility behaves, what exact edge option premium sellers have and how to take advantage of this edge. I have mentioned this edge a few times throughout my Intermediate course. However, I have never gone into the details. That is what this article is dedicated to.
Check out the following video in which I break down how to effectively trade options like an insurance firm.
Historical Volatility vs Implied Volatility – Is There An Edge?
Implied volatility (IV) is the expected volatility and it can be derived from option’s prices. Usually, when option’s prices are high, implied volatility also is high and vice versa.
It is very important to understand that implied volatility (IV) is not the same as actual or historical volatility (HV). Implied volatility is the expected volatility meaning that it is forward-looking, whereas the actual volatility is backward-looking. Implied volatility is trying to predict the actual volatility.
Here is an analogy to help with the understanding of historical volatility vs implied volatility: the weather forecast. The weather forecast tries to predict the future weather. But is the forecasted weather always the same as the actual future weather?
No. In our day and age, technology has come very far, but nevertheless, the forecasted weather isn’t always the same as the actual weather. Sometimes, the forecast is spot on and other times it isn’t even close.
The same is the case for implied and actual volatility. The forecasted volatility (IV) is not always the same as the actual volatility (HV).
This means implied volatility is the only factor in options pricing models that is not observable. All the other factors are precise and can be measured: strike price, expiration date, the price of the underlying… Implied volatility can only be calculated if you know all the other variables. But don’t worry, you won’t have to calculate IV yourself. Nowadays, every good broker platform will calculate IV for you.
If you compare historical volatility vs implied volatility over the years, you can recognize an interesting pattern. The following two charts compare the S&P 500’s implied volatility (VIX) to the S&P 500’s actual volatility.
Can you recognize anything special?
The vast majority of the time, implied volatility has been higher than the actual volatility. The market has expected more than actually happened most of the time. In fact, a research report from Cambridge Associates states that implied volatility has overestimated historical volatility almost 87% of the time between 1990 and March of 2011.
Think about this for a second. What does this mean for option traders?
If option’s prices tend to be high in times of high implied volatility and implied volatility usually, has been higher than actual volatility that means that options have been overpriced most of the time. This means that option sellers have an edge because they are selling these too expensive options.
That is why option premium selling works!
Just look at the following historical vs implied volatility chart. The red parts are the periods during which IV was overstating HV and the green parts are the periods during which IV was understating HV. As you can see, implied volatility was overstating historical volatility most of the time!
Think of options selling as an insurance company. Insurance companies sell you insurance because they know that statistically, they won’t have to pay out a lot of insurances.
The same goes for options selling. You sell options because you know that statistical options have been overpriced and you, therefore, have an edge.
Note that this edge doesn’t exist all the time. Implied volatility has been overstating historical volatility most of the time, but not all the time. Sometimes, the opposite was the case and other times implied and historical volatility has been more or less the same.
So how do we know if we have an edge or not?
We don’t. You can’t tell when implied volatility is going to overestimate actual volatility. That is also one reason why you should keep your position size small. Just because there is a statistical edge does not mean that that edge exists all the time. Sometimes, trades will go against you. To stay in the game, it is essential to trade small. Ideally, you should risk less than 5% per trade.
If you want to learn how to take full advantage of this edge, make sure to check out my free options trading education!
The Behavior of Volatility
Hopefully, you have realized by now that volatility plays a huge role in the world of options trading. Therefore, it is very important to be familiar with the behavior of volatility when selling options.
Volatility moves very differently than stock prices. Volatility is a mean-reverting asset. It usually trades around a mean and if it moves from this mean it tends to revert back to it relatively fast.
Just look at the following chart. It is a chart of VIX, an index that measures the S&P 500’s implied volatility.
As you can see, implied volatility does not move like most other prices or have you seen a chart similar to the above as a stock chart before?
The mean on the VIX chart above is somewhere around 20. The price never really deviates from this mean a lot for long periods of time. Most spikes are followed by big drops back to this average.
So how can an option trader take advantage of this mean-reverting behavior of volatility?
Option selling strategies usually have a negative Vega which means that they profit from decreasing IV and lose value from increasing IV. This means an option trader could sell options when implied volatility is high and thereby ride the volatility back down to its mean.
It can be very hard to predict these big spikes in volatility. However, it is not near as hard to predict the big drop back down after a spike. Therefore, you should focus on options selling strategies that profit from decreasing IV instead of focusing on option buying strategies that profit from increasing IV.
So make sure to always look at IV and focus on high IV assets for your options selling. To find out if IV currently is high or low, use IV Rank. IV is considered relatively high when IV Rank is over 50. However, the higher IV Rank is, the better. When IV is very high and IV Rank is near 100, you could consider increasing position size to some extent.
The Importance of a Long-Term Approach
It is very important to have a long-term approach to option selling. Otherwise, you won’t be able to take (full) advantage of the overstating implied volatility.
You can’t tell if option premium selling works after a few days, weeks or probably even months. A few trades just aren’t a big enough sample size.
Remember, you have a statistical edge. To take advantage of this statistical edge, you will have to have a large enough number of occurrences.
Let me give you an example of a casino:
For the sake of this example, I will focus on the game of roulette. It is generally known that the casino has a statistical edge in roulette (or in any game that they offer). That is also why the casino is the one making money and not its customers.
Now think about the strategy that casinos use to make the most money with roulette.
They want their customers to play as many games with relatively small bets per game. Why is this the case?
Because they know that the bigger their sample size, the closer the actual outcome will become to the expected outcome. This is also referred to as the law of large numbers. Casinos usually have betting limits meaning that you can’t bet more than a certain amount on a single game of roulette.
These betting limits exist because the casino knows that their edge isn’t that great on a single game. They ‘only’ have an edge of a few percents. Over the long run with a large enough number of occurrences, these few percents are more than enough to make the casino rich. However, in a single game, these few percents aren’t enough to guarantee the casino a profit.
You should think the same way about your options trading. Try to trade like a casino: small and often. The greater your number of occurrences, the more you will be able to take advantage of the overstating IV. Furthermore, always remember, that your edge isn’t great on a single trade and therefore, you should keep your position size small!
This does not mean that you have to put on 100 trades right away. It just means that you should have a long-term approach. You shouldn’t expect to be profitable on every single trade. You should trust the numbers just like a casino. The bigger the sample size of good trades, the better. So 1000 trades are better than 10 trades.
Once again, I am not saying that you should put on tons of trades straight away. It is totally fine if 1000 trades will take you years. Just stick to it and don’t give up after a few trades because a few trades aren’t enough to take advantage of a statistical edge.
Consistency is Only Half of the Equation
As you can see, consistency is key. In the long run, the numbers should work themselves out.
With that being said, it is essential to understand that consistency isn’t everything. If you consistently put on bad trades, you won’t become a successful trader. It is paramount to your success as an options trader to follow all the steps and thereby, focus on putting on good trades only.
- You should always be on the right side of implied volatility!
- You should always keep position sizing small!
- You should focus on option premium-selling strategies!
- You should manage your positions correctly!
If you just skip one of the steps, it can be detrimental to your success. For instance, if you aren’t taking IV into account, you could be missing out on the edge that makes option premium selling a viable strategy.
So make sure to be consistent and stick to all the rules!
To learn all the rules, make sure to check out my free options trading courses!
In conclusion, it is important to understand the differences between historical volatility vs implied volatility:
Implied volatility is the expected volatility, whereas historical volatility is the actual volatility.
Statistically speaking, implied volatility has been overstating historical volatility most of the time. This gives option sellers an edge.
It is best to trade option selling strategies in times of high implied volatility due to their negative Vega and the mean-reverting nature of volatility.
Furthermore, it is essential to have a long-term approach to option selling!
Last but not least, it is very important to be consistent and disciplined with your trading!
If you have any questions or comments, make sure to let me know in the comment section below!
If you are reading this as a part of the Intermediate Course, you can move on to the Intermediate Course Quiz now.