The foundation of your strategy rests on a concept known as “mean reversion.” This is especially true for Volatilty traders.
Mean Reversion in Options Trading
In finance, mean reversion is the tendency of a financial instrument’s price to move toward its average over time. If we apply that definition to volatility, then it it the assumption that an option’s volatility “price” will tend to move toward its average over time.
Consequently, a mean reversion trade expresses the thesis that an asset has deviated too far from its real value – or at least from its mean price – and that opportunities for profit exist when reversion to the mean occurs.
Mean reversion in options trading is best understood through the lens of historical and implied volatility,
- Historical Volatility: Every stock has a specific opening and closing price for each trading day of its existence. That data can be used to compute what’s known as historical volatility, which measures the amount the price of a stock has varied over a defined period of time.
- Implied Volatility: One can look at the bid/ask of a particular option (symbol, strike, and duration) and observe at what price trades are being executed. This value represents the current market price for volatility. Implied volatility is derived from current market prices and reflects the market’s expectation for movement in the underlying over the duration of the contract.
Here is an example of mean reversion
Looking at an example, consider theoretical stock XYZ that has a one month historical volatility of 20. If options with a one month duration in XYZ are trading with an implied volatility of 29, an opportunity theoretically exists to sell that option with the expectation that actual volatility in the underlying over the upcoming one month period will be less than 29 (and potentially closer to 20).
By no means does this mean profit in such a trade is 100% assured because future volatility is unknown. However, it has been observed that options prices are mean reverting on average. Consequently, a portfolio driven by a high probability strategy such as this should be profitable, on average, over time.
The metric of Implied Volatility Rank, or IVR, can be used to identify trading opportunities.
- Implied Volatility Rank (IVR) tells us whether implied volatility is high or low in a specific underlying based on the past year of implied volatility data. For example, if XYZ has had an implied volatility between 30 and 60 over the past year and implied volatility is currently trading at 45, XYZ would have an IVR of 50%.
- When IVR is high (above 50%), we can expect a contraction. When IVR is low (below 50%), we can expect an expansion. IVR helps us put context around the implied volatility of an underlying (stock).
Strategy decisions can be made using IVR
IVR helps us decide whether to use a credit or debit strategy. While other considerations need to be taken into account, an IVR above 50% might be indicative of good options selling opportunities, while an IVR below 20% might be indicative of buying opportunities. Both considerations take into account the mean reverting nature of volatility.
If you would like to explore these topics further, we encourage you to leverage the Learn tab on the tastytrade homepage or by leveraging the search engine on the website.
For more information on Mean Reversion see:
- The Skinny On Options Math from December 5th, 2015: “Mean Reversion”
From Theory To Practice from February 12th, 2016: “VX Mean Reversion”
- Options Jive from May 6th, 2016: Mean Reversion of Volatility
Content derived from research at tastytrade.com