What is Implied Volatility Rank?
The implied volatility of a stock is the prediction of its future market price. The Implied Volatility Rank ranks implied volatility against the past year of Implied Volatility values for a stock or another commodity. It tells investors where the current Implied Volatility ranks compared to the past year.
Implied Volatility Rank
Investors commonly use implied volatility values to calculate contract prices. When the implied volatility is high, it means that a stock’s futures will be priced at a higher rate (premium pricing). The reverse will also be true, and low implied volatility means that contracts are priced at a discount.
The implied volatility rank simply compares the current value of the implied volatility against the year long history of IV values.
So, for example, if the IV values of a share range between 50 to 100 and the current value is 70, the share’s implied volatility rank will be 60%.
The implied volatility rank is an add-on index that helps investors know where the stock’s potential volatility stands compared to the entire year. In addition, it adds context to the implied volatility value, making it easier for investors to decide.
What Implied Volatility Rank Shows about Stocks
As a trader, remember that implied volatility can be calculated through probability.
If you are not aware of what Implied Volatility is or how it is calculated, visit here to learn all about a long volatility strategy and here about an implied earnings move.
Implied volatility gives investors and traders a forecast of future prices. In short, it gives them a range of prices to expect. Investors use this range to plan their investments, trade entries, and exits.
Implied volatility rank simplifies the entire process by giving investors a status of where the share’s price volatility is ranking compared to its price volatility for the year.
Stocks have different performances, and their volatilities are also different.
For example, stock B may be trading at an implied volatility of 30% and a rank of 20%, while Stock A is trading at the implied volatility of 40% and a position of 60%.
For traders, the rank of stock B at 20% shows that the stock is at a low of its year-long range and could signal investors to enter a new position as the stock price dips.
Conversely, in the case of stock A, the high rank means that the stock is peaking towards its year-long high and could mark the exit for some investors from their open positions in the stock.
Explaining the Implied Volatility Rank Calculation
Implied volatility rank (IV rank) ranks a stock’s present implied volatility to its implied volatility range over a specific time, usually a year.
The formula for the implied volatility rank calculation is as follows:
Present implied volatility – (selected period’s implied volatility low point)
(selected period’s implied volatility high point) - (selected period’s implied volatility low point)
For instance, the IV rank for a 30% IV stock with a annual implied volatility range between 15% and 50% would be:
30% - 15% = 15% = 42%
50% -15% 35%
The IV rank of 42% shows that the gap between the present implied volatility and the lowest implied volatility for the year is just 42% of the implied volatility range for the past year.
This tells us that the current implied volatility is at the midpoint of the historical volatility.
An implied volatility rank closer to 0% shows that the present implied volatility is the lowest of the year long range. Conversely, an implied volatility rank closer to 100% indicates that the current implied volatility is at the highest of the year long range.
Applying Implied Volatility Rank
So how does the implied volatility rank help an investor? How do we apply the information to our trades? Traders that use implied volatility and IV rank use it as a guideline for their strategies about the stock.
For example, if the IV Rank is 80%, the trader can initiate trades that will benefit from a reduction in implied volatility. Since implied volatility rank of 80% shows that the IV is peaking for the period it is viewed for.
If the implied volatility rank is low, at 15% may be, the trader can plan strategies for the implied volatility to rise. Using implied volatility rank helps traders plan out their trades in a more strategic manner.
Advantages and Disadvantages of Implied Volatility Rank
One major disadvantage of implied volatility rank is that it is a relative or comparative scale of value. This means that it shows where the current implied volatility ranks compared to its past year (or whatever period you pick).
Now, if at some time during that period, the implied volatility shot up or down abnormally, then the rank from that point onwards will be skewed.
If the implied volatility rises, then subsequent values of implied volatility will always seem low (compared to that high). Conversely, if the implied volatility fell, the implied volatility rank from that point onwards will always seem to be increased. This disadvantage affects effective decision-making.
This is demonstrated in the figure below:
If you look at the part of the chart before July 2015, you can see the S&P 500’s simplied volatility range is between 10% -25%, and the implied volatility rank for the same period showed ranks between 50% – 75%.
However, after the massive peak of 40% in implied volatility between July and September, the implied volatility rank fell to under 50%, even though implied volatility continued to range between 15% - 25%. This is because the implied volatility rank gets distorted after fluctuations in implied volatility.
To conclude, implied volatility rank is a handy measure for assessing stocks' present level of implied volatility compared to their historical levels. The rank also allows sound strategy development based on the ranking offered, provided that any skews are considered and accounted for.