Trading Implied Volatility
With a typical option, the sensitivity of delta overshadows that of vega. To
try and profit from a rise or fall in IV, one has to trade delta neutral to
eliminate immediate directional sensitivity. There are many strategies that
can be traded as delta-neutral IV strategies simply by adding stock.
Throughout this chapter, I will continue using a single option leg with
stock, since it provides a simple yet practical example. It’s important to note
that delta-neutral trading does not refer to a specific strategy; it refers to the
fact that the trader is indifferent to direction. Direction isn’t being traded,
volatility is.
Volatility trading is fundamentally different from other types of trading.
While stocks can rise to infinity or decline to zero, volatility can’t. Implied
volatility, in some situations, can rise to lofty levels of 100, 200, or even
higher. But in the long-run, these high levels are not sustainable for most
stocks. Furthermore, an IV of zero means that the options have no extrinsic
value at all. Now that we have established that the thresholds of volatility
are not as high as infinity and not as low as zero, where exactly are they?
The limits to how high or low IV can go are not lines in the sand. They are
more like tides that ebb and flow, but normally come up only so far onto the
beach.
The volatility of an individual stock tends to trade within a range that can
be unique to that particular stock. This can be observed by studying a chart
of recent volatility. When IV deviates from the range, it is typical for it to
return to the range. This is called reversion to the mean , which was
discussed in Chapter 3. IV can get stretched in either direction like a rubber
band but then tends to snap back to its original shape.
There are many examples of situations where reversion to the mean enters
into trading. In some, volatility temporarily dips below the typical range,
and in some, it rises beyond the recent range. One of the most common
examples is the rush and the crush.