Why We Sell High Volatility | Understanding IV Rank

Why We Sell High Volatility: A Detailed Breakdown

Key Concepts:

• Implied Volatility (IV): The market's forecast of a likely movement in a financial instrument over a specific period.
• Implied Volatility Rank (IVR): A metric indicating where the current IV sits within its historical one-year range, expressed as a percentile.
• Mean Reversion: The tendency of an asset's price to revert to its average price over time.
• Theta: The rate of time decay of an option's value.
• Positive Drift (Market Prices): The general tendency of market prices to increase over time.
• Negative Drift (Volatility): The tendency of volatility to decrease over time, correlated with positive market drift.
• VIX: The CBOE Volatility Index, a real-time market index representing the market's expectation of 30-day volatility.

I. Understanding High Volatility

The core premise is that selling options during periods of high volatility is a strategically advantageous approach. This isn’t about how or when to sell, but why it’s effective. Two key metrics are used to define high volatility: Implied Volatility (IV) and Implied Volatility Rank (IVR). While both are important, the speaker emphasizes the utility of IVR.

IVR places current IV within a one-year historical context. An IVR of 75 signifies that current IV is in the 75th percentile of its past year’s range – a high volatility environment. Conversely, an IVR of 15 indicates low volatility, with current IV in the 15th percentile. Tastytrade generally considers an IVR of 30 or higher as a threshold for considering short premium strategies. The speaker notes that even with suppressed volatility over the last decade, an IVR of 30 is a reliable starting point for effective premium selling.

II. Reason 1: Volatility Tends to Contract

Volatility inherently seeks a lower range. There’s a reliably inverse relationship between market prices and market volatility. As markets generally trend upwards over time (positive drift – 8%, 10%, 12% annual gains are cited as examples), volatility tends to decrease (negative drift). This isn’t a perfect one-to-one correlation, but a consistent pattern.

The speaker points to the VIX chart as empirical evidence, noting its tendency to gravitate towards the lower end of its range (17, 16, 15, 13, 11, 9, even single digits in 2017). While volatility spikes occur, it consistently reverts towards lower levels.

III. Reason 2: Volatility Mean Reverts

Volatility spikes are typically triggered by fear and uncertainty – events like earnings reports, FOMC meetings, or unforeseen geopolitical events. These events create a temporary disruption in market understanding, leading to increased option prices and IV. However, this state is unsustainable.

Once clarity emerges (earnings are reported, Fed decisions are made), the market adjusts, and volatility tends to subside, often rapidly. This phenomenon is known as mean reversion – volatility returning to its long-term average. This applies in both directions; low volatility also tends to expand, but the pressure to revert down from high levels is stronger due to its natural tendency to reside on the lower end of the range.

IV. Combining the Forces: A Powerful Strategy

Selling options during high volatility leverages both of these tendencies.

• Selling an Expensive Asset: High IV means options are overpriced, providing a favorable entry point for sellers.
• Volatility Contraction & Mean Reversion: The inherent tendency of volatility to decrease amplifies the benefits of selling premium.

These forces are further enhanced by:

• Positive Theta: Time decay works in favor of the option seller.
• Out-of-the-Money Strikes: Selecting strikes far from the current price increases the probability of success.

V. Capital Allocation & Risk Management

While selling premium in all volatility environments can be considered, the speaker cautions against allocating all capital to high-volatility environments. He acknowledges some traders may want to keep capital consistently deployed, but advises against overexposure when the VIX is low (e.g., 15, 13, 17) to avoid significant losses during inevitable volatility spikes (to 20, 25, or 29).

VI. Notable Quotes

• “Volatility wants to contract over time. It likes to live on the lower end of the range.”
• “With the reliably inverse relationship between market prices and market volatility… you are naturally going to see as the market begins to move higher over time, volatility is going to begin to move lower over time.”
• “Volatility has a tendency to mean revert over time.”

VII. Synthesis & Conclusion

The core takeaway is that selling high volatility is a statistically sound strategy based on the inherent characteristics of volatility itself. By capitalizing on its tendency to contract and mean revert, alongside the benefits of theta decay and strategic strike selection, traders can build a robust and profitable premium-selling portfolio. The key is to identify periods of elevated volatility (IVR of 30 or higher) and patiently allow these forces to work in their favor, employing a disciplined, small-size, trade-off approach. The strategy isn’t foolproof, but the empirical evidence and long-term perspective suggest a significant edge for those who understand and embrace these principles.