The entire game of options trading depends on when to buy volatility and when to sell volatility. As we have already been told that we should usually try to sell when IV is higher and buy when IV is lower. The simple reason is premium is lower when implied volatility is low and vice versa.
The million-dollar question is how to know IV is low and high. To solve this problem, we use a term called IV percentile.
Understanding IV Percentile
Volatility always tends to revert to mean like a time series. If it is high, there is a good chance, it will reduce and if it’s lower, it will go up. In general, it tends to revert to mean.
- IV is called high when it is higher than the average volatility of the underlying financial instrument during a year.
- IV is considered lower when it is lower than the average volatility of the underlying instrument for the year.
How to Use IV Percentile in Option Trading
Let us take an example. Nifty has an IV of 18.1, is it high or low? This cannot be determined unless there is a reference point. Should I buy or sell this option? How can I understand these IV numbers in a meaningful way to get tradeable insights?
However, if I say you that the historic VIX of Nifty has been 8.5, you know instantly that the current IV is more than 100% higher than the historic IV. So, it’s not the time to buy, but you can start thinking about searching for an option selling strategy.
Also, IV is stock or commodity-specific. Stocks like Dabur or Bata will have lower IV than Adani Enterprises and avoid the temptation to jump to conclusions instantly.
To know more, also read this article: https://besensibull.medium.com/how-high-is-high-the-iv-percentile-11c8d80840b5
Therefore, keep these rules in mind. I am repeating it as they are important:
- Debit strategies work better in low IV conditions.
- Credit strategies work better in high IV conditions.
- Credit strategies should be avoided in low IV conditions (There are exceptions to this, but we will discuss it later)
- Debit strategies are better avoided in high IV conditions.
The biggest advantage of the IV percentile is it gives you an idea of whether your strategy has the probability of going right or wrong.