Now that implied volatility has popped, and the VIX is trading a bit closer to its historical average, one pertinent question is how implied volatility tends to behave when it declines.
It should be noted that implied volatility can remain high for an extended period of time - it all depends on the circumstances. However, it does eventually drop - history clearly illustrates that.
If you are looking to better understand the "typical" behavior of implied volatility when it does decline, we highly recommend tuning in to a recent episode of Market Measures.
As clarified on the show, the VIX is a measure for implied volatility in the S&P 500. It is generally indicative of the expected move in the S&P 500 over the next year. For example, if the VIX is trading at 15, that implies that the S&P 500 is expected to move between +15% and -15% within the next year.
As we know from past tastytrade studies, which have utilized a wide range of historical data, actual volatility (aka realized volatility) tends to be less than expected volatility (aka implied volatility), on average. That reality is a big part of the rationale underlying the short volatility approach.
Whether you buy into the short premium philosophy or not, let's briefly take on the persona of a hypothetical trader that believes wholeheartedly in the power of mean reversion as it relates to short volatility.
For this hypothetical short volatility trader, one of the paramount questions is how implied volatility behaves when it declines, particularly according to historical data. While history doesn't necessarily indicate what will happen in the future, it at least gives us an idea of what has happened before, and helps set realistic expectations.
Using the above guidelines, the Market Measures team designed a study which simply looked back in history and asked "how often (on average) did the VIX drop between trade entry and trade exit, and how often (on average) did the VIX rise between trade entry and trade exit?”
While this won't tell us with any certainty what will happen going forward, it at least tells us how the VIX has performed in the past during the life of our trades.
The underlying used to backtest this question was SPY, using data from 2005 to 2017. The trading strategy backtested was a simple 16-delta short strangle in SPY.
The graphic below summarizes the results of this study, and shows us that on average, the VIX tends to drop between trade entry and trade closure about 54% of the time, over the period examined:
One critical piece of data to review in the slide above is to recognize how our P/L spiked considerably for the trades that saw a decline in implied volatility from trade entry to trade exit.
The above tells us that the VIX tends to drop the majority of the time during the lifetime of a trade, and that when the VIX drops during this period, our P/L tends to benefit.
Now let’s look at the second phase of the study, which provided some additional insights.
In this segment of the study, the Market Measures team decided to use Implied Volatility Rank (IVR) to help us better understand whether implied volatility declined in a different fashion across different trading conditions.
For example, when market volatility is heightened, so too is Implied Volatility Rank. Therefore, we can categorize all of the historical occurrences from the study into their specific range of IVR.
Meaning all trades in which IVR was greater than 20 could be grouped together, all trades when IVR was greater than 30, and so on.
The team used these groupings and reran the backtest to observe how often implied volatility declined from trade entry to trade exit, based on IVR grouping.
As you can see below, for instances in which IVR was above 50%, the probability that implied volatility would decline between trade entry and trade exit was considerably higher:
Based on the above data, we now can highlight two important takeaways from the study:
When implied volatility drops between trade entry and trade exit, we earn higher profits
Entering a trade with higher Implied Volatility Rank (IVR) increases the likelihood that implied volatility will drop, and bring the above-mentioned benefits (all else being equal)
While it’s extremely difficult to predict when implied volatility will decline, the findings presented on this episode of Market Measures can help us better understand the tendencies of declining volatility, based on an analysis of historical data.
We hope you’ll take the time to review the complete episode when your schedule allows.
If you have any comments or questions on this material, don’t hesitate to leave a message in the space below, or reach out to @tastytrade on Twitter or send an email to firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
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