are a few observations to be made that can help a trader make better-
educated decisions about IV.
Reversion to the Mean
The IVs of the options on many stocks and indexes tend to trade in a range
unique to those option classes. This is referred to as the mean—or average
—volatility level. Some securities will have smaller mean IV ranges than
others. The range being observed should be established for a period long
enough to confirm that it is a typical IV for the security, not just a
temporary anomaly. Traders should study IV over the most recent 6-month
period. When IV has changed significantly during that period, a 12-month
study may be necessary. Deviations from this range, either above or below
the established mean range, will occur from time to time. When following a
breakout from the established range, it is common for IV to revert back to
its normal range. This is commonly called reversion to the mean among
volatility watchers.
The challenge is recognizing when things change and when they stay the
same. If the fundamentals of the stock change in such a way as to give the
options market reason to believe the stock will now be more or less volatile
on an ongoing basis than it typically has been in the recent past, the IV may
not revert to the mean. Instead, a new mean volatility level may be
established.
When considering the likelihood of whether IV will revert to recent levels
after it has deviated or find a new range, the time horizon and changes in
the marketplace must be taken into account. For example, between 1998
and 2003 the mean volatility level of the SPX was around 20 percent to 30
percent. By the latter half of 2006, the mean IV was in the range of 10
percent to 13 percent. The difference was that between 1998 and 2003 was
the buildup of “the tech bubble,” as it was called by the financial media.
Market volatility ultimately leveled off in 2003.
In a later era, between the fall of 2010 and late summer of 2011 SPX
implied volatility settled in to trade mostly between 12 and 20 percent. But
in August 2011, as the European debt crisis heated up, a new, more volatile
range between 24 and 40 percent reigned for some time.