Volatility can be defined as the estimated uncertainty of the underlying price of a security. Implied Volatility typically increases when the market is Bearish and decreases when the market is Bullish. Volatility is a barometer of uncertainty. You have to study Volatility in order to make sure that you can design a strategy that has high Probability of Success when trading. Selling Option when Volatility is low and buying Option when the Volatility is high decreases the Probability of Success, and vice versa.
Implied Volatility Rank
Supply and demand for option contracts determine Implied Volatility. Market Price, Interest Rate, Expiration Date, Strike Price and Implied Volatility are all used in calculating the option premium. One of the most commonly used models to derive Implied Volatility is the Black-Scholes Model. Implied Volatility shows future price uncertainty, that is, it shows you supply and demand of buyers and sellers for the Option Strike Price by a certain date.
To recap, IV Rank or Implied Volatility Rank is calculated by dividing the difference of today’s IV value and the lowest IV value in the past 52 weeks by the difference of the highest IV value and the lowest IV value in the past 52 weeks.
IV Rank = (IV – LowIV)/(HighIV – LowIV)
This gives you a relative value of Volatility today versus the past 52 weeks. Study Implied Volatility to see how it behaves before and after any binary event of the underlying asset. As a general rule, volatility below its 52-week average is a buying opportunity and Volatility above its historical 52-week average is a selling opportunity.
Again, IV Rank can be used to determine when to buy or sell options: Buy when the IV is low and you sell when the IV is high. Also note that the IV tends to revert to its mean before and after any binary event. In Figure 25, IV is represented by the green line.