We like to selling option premium in high Implied Volatility (IV) environments because, in part, we are convinced that when IV is high it will eventually contract and revert to the mean. Metrics we have created, such as Implied Volatility Rank (IVR), help us in knowing when IV is high or low and should revert to the mean, but what is that mean?
A graph of the S&P 500 Volatility Index, the VIX was displayed. The graph showed the 20-day, 50-day and 250-day mean. The graph showed the importance of staying consistent with your discipline and strategy. A second graph comparing the 20-day mean to the 50-day mean of the VIX was displayed. The graph showed that a trader looking at the 50-day mean might think volatility is undervalued while traders looking at the 20-day mean might think it’s overvalued.
So how do we decide which mean should be used when determining whether volatility is expensive or cheap? A graph of mean implied volatility in which a specific trade’s Days To Expiration (DTE) was taken into account was displayed. The graph compared the 1-year moving average to the 45-day moving average. Examples and their formulas for weighting to the short term and long term to establish a mean volatility for reversion was displayed. This can help with consistency and confidence. Establishing a mean volatility can aid traders when choosing between debit and credit spreads and deciding how aggressive to be when selling premium.
For more information on Mean Reversion see:
From Theory To Practice from February 12, 2016: " VX Mean Reversion"
Options Jive from May 6, 2016: "Mean Reversion of Volatility"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the key takeaways and a better understanding of what mean volatility we should use in determining whether implied volatility is high or low.
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