Using Implied Volatility to Screen for Option Trades (Part 2)

Since many people believe IV is mean-reverting, I discussed the idea of generating trade ideas by looking for stocks at IV extremes. Today I will continue that discussion.

We want to look for stocks with high IV. Once we have found these candidates, we can then plan trades that take advantage of an anticipated IV drop from these extremely levels back toward average levels.

Here is a key point to differentiate, though: we want stocks with high IV relative to their own average IV as opposed to high on an absolute basis (i.e. compared to other stocks). I will call this IV percentile: where current IV falls within the low-high IV range over the past year. IV percentile of 100 (0) means current IV is at its highest (lowest) level over the past 12 months.

We can also invoke that second trade consideration and determine whether we have a forecast for the underlying stock price. If we are wrong with IV forecast then we might still make money if we are right on stock movement (and vice versa). For the latter, we would look to use bullish or bearish premium-selling strategies (e.g. naked options or credit spreads) if we are decidedly bullish or bearish, respectively. If we believe that price will remain in a range then we can use strategies that are short premium to the upside and downside: short straddles, short strangles, or iron condors.

Any option scanning tool should allow us to scan for IV. You can choose whatever specific criteria you like. Since I have no reason to think any one set of criteria will perform better than any other, here is a generic screen:

1. Last stock price at least $15 (low-priced stocks may have wide strike increments)

2. Average daily volume of the underlying > 1,000,000 (liquidity requirement)

3. Average true range of price between 1-8%

4. IV Percentile > 95

I will conclude with the next post.