- 7 Aug 2018
- By Dave Lerman
- Topics: General Education

It has often been said that while futures are two-dimensional instruments, options tend to be four-dimensional instruments. With futures, you are generally concerned only with up and down direction, while with options, you must deal with the ups and downs of the underlying as well as time decay and changes in implied volatility. Too often, beginners, and even more experienced traders, ignore volatility, which can lead to sub-optimal results.

In this paper we will discuss volatility from a slightly different perspective. We will attempt to distinguish average levels of volatility from above average volatility and measure the extremes of volatility on both the high-side and low-side. The goal: to formulate more proactive strategies by taking into account the current volatility environment. What do we mean by that? Many options traders are familiar with a straddle where you buy a call and a put with the same expiry and same strike price. Ideally, you want to execute long straddle positions in low volatility environments with the expectation that vol (vol = volatility) will rise significantly in the near future. The problem is many traders make the mistake of doing such a strategy in higher volatility environments. Doing so carries more risk and a reduced chance of profiting from the trade.

Hence it might be worthwhile to look beyond a volatility chart to determine the state of volatility and instead look at implied volatility percentile rankings. Volatility percentile rankings allow the trader to grade current volatilities in terms of what is high, what is exceedingly high versus what is low versus what is historically low as well as average levels of volatility.

Looking at Figure 1 below you will see a typical chart that looks at implied volatility over some period of time. You get some sense of highs and lows, observing that volatility rarely gets above 20-25% and rarely goes below 7-8%. Ideally, a trader may want to buy low and sell high with volatility as well. Higher vol helps a long options position and lower vol hurts a long options position (all other things being equal). This is because at higher volatility, there is a greater chance of going through strike prices. Hence, traders are willing to pay higher prices and sellers of options demand more premium in return for the added risk.

On the other hand, Figure 2 shows a table with implied volatility percentile rankings. Both Figure 1 and 2 use the same data, just reformulated to allow a deeper dive into a volatility gradient. Implied volatility percentile rankings work much like the college entrance exams that many of us are familiar with. If you took, for example, the SAT test, you received two scores: a raw score and a percentile ranking. If you scored a 790 on the math section, you were in the 99th percentile. That is, you beat 99% of those who took the test and likely went on to a prestigious university. If you scored a 300, you were in the 10th percentile and would probably want to retake the exam as 90% of those taking the exam scored higher.

Volatility percentile rankings work the same way. We took the implied volatility numbers each day and ranked them using a percentile generator in excel. Figure 2 shows the implied volatility percentile rankings for the E-mini S&P 500® options on futures. The data was taken each day from over the last three years, ending with July 16, 2018. The implied vol is the ATM straddle using a 30-day expiry (constant maturity).

Percentile Ranking | E-mini S&P 500® | Est. ATM Straddle* |
---|---|---|

High |
34.03 |
218.12 ($10,906) |

90th percentile |
18.34 |
117.32 ($5,866) |

75th percentile |
13.80 |
88.13 ($4,407) |

50th percentile |
11.30 |
72.06 ($3,603) |

25th percentile |
9.03 |
57.47 ($2,873) |

10th percentile |
7.59 |
48.21 ($2,411) |

Low |
6.50 |
41.20 ($2,060) |

*2815 straddle (ATM), 30 days to expiry

The highest implied volatility during this 3-year window was 34.03.

The 90th percentile level was an implied vol of 18.34%

The 75th percentile level was an implied vol of 13.8%

The 50th percentile level was an implied vol of 11.3%

The 25th percentile level was an implied vol of 9.03%

The 10th percentile level was an implied vol of 7.59%

The lowest implied vol during that three-year window was 6.5.

So, say today’s implied volatility was calculated to be 7.59%. This would put it at the 10th percentile—i.e. 92% of the time implied volatility was higher. Higher volatility helps long options positions. Traders get long premium (straddles, strangles, etc…) in anticipation of higher vol in the near future (the last column of Figure 2 shows the ATM straddle in premium terms).

At the 10th percentile the ATM straddle would cost the buyer 48.21. But the price of the same straddle at the 50th percentile is a much higher 72.06—a substantial difference.

For those inclined to sell options premium, the goal would be to do so in higher vol environments such as the 75-90th percentile. But remember, selling options carries unlimited risk. Hence, risk management capabilities must be spot on and the account large enough to withstand the added risk. Most importantly, percentile rankings can help manage risk. If a mistake is to be made with an options purchase, better to be wrong buying premium in the 10th percentile than in the 90th percentile. Just notice the difference in the premiums of the ATM straddle in Figure 2 at the 10th percentile and the 90th percentile. The straddle at the 90th percentile is more than twice as expensive. Being wrong in the 10th percentile would cost significantly less in the case of maximum loss.

Repeating what we said earlier, buy low / sell high pertains to an option’s implied volatility too. The crux of these tables is to showcase that buying options premium in the lower percentile rankings and selling options premium in the higher percentile environments might lead to better results for the trader. Volatility percentile rankings can help the trader align the correct strategy for the correct volatility environment.

In the pages that follow, we have provided the volatility percentile rankings for many of CME Group’s core products. The data is for the three-year period ending July, 16, 2018.

Percentile Ranking | E-mini S&P 500® (ES) | E-mini Nasdaq 100® (NQ) |
E-mini Russell 2000®(RTO) | U.S. Treasury Note (OZN) | U.S. Treasury Bond (OZB) | Eurodollar (GE) |
---|---|---|---|---|---|---|

High |
34.03 |
39.27 |
27.91 |
7.43 |
14.93 |
50.36 |

90th percentile |
18.34 |
22.13 |
17.15 |
5.54 |
11.73 |
36.07 |

75th percentile |
13.80 |
16.94 |
14.78 |
5.10 |
10.76 |
32.20 |

50th percentile |
11.30 |
14.33 |
13.21 |
4.65 |
9.62 |
27.79 |

25th percentile |
9.03 |
12.49 |
12.19 |
3.92 |
7.58 |
23.19 |

10th percentile |
7.59 |
11.09 |
11.37 |
3.58 |
7.14 |
19.88 |

Low |
6.50 |
8.73 |
7.62 |
3.12 |
6.21 |
9.14 |

Percentile Ranking |
Crude Oil (LO) |
Natural Gas (LN) |
Gold (OG) |
Soybeans (OZS) |
Corn (OZC) |
---|---|---|---|---|---|

High |
79.79 |
62.20 |
26.39 |
36.11 |
42.29 |

90th percentile |
46.97 |
51.84 |
16.80 |
24.84 |
29.27 |

75th percentile |
40.56 |
45.55 |
15.12 |
20.23 |
24.57 |

50th percentile |
30.74 |
38.74 |
12.94 |
17.07 |
19.66 |

25th percentile |
25.24 |
33.76 |
10.09 |
14.71 |
15.99 |

10th percentile |
23.12 |
23.62 |
9.24 |
12.24 |
13.10 |

Low |
15.74 |
20.89 |
7.80 |
9.77 |
9.82 |

Percentile Ranking |
JPY/USD (JPU) |
EUR/USD (EUU) |
GBP/USD (GPU) |
---|---|---|---|

High |
14.57 |
14.43 |
13.15 |

90th percentile |
12.47 |
9.76 |
10.52 |

75th percentile |
10.61 |
8.54 |
9.52 |

50th percentile |
8.78 |
7.77 |
8.19 |

25th percentile |
7.86 |
6.96 |
7.55 |

10th percentile |
6.92 |
6.24 |
7.03 |

Low |
5.93 |
5.16 |
5.76 |

Several years ago a broker and one of his larger clients witnessed the market treading water for months and volatility creeping lower and lower with each passing week. The client and broker decided to sell a large number of straddles in the S&P 500® futures to take advantage of the time decay inherent in straddle selling.

At that particular time, volatility was running at 7.1%. The lowest it had been in the last decade was 6.9%. In fact, at 7.1%, it was in the 2nd percentile. 98% of the time volatility is higher than 7.1% and when volatility heads higher, it has a negative impact on short straddles. Statistically speaking, the probability favored higher vol. But vol could remain low and the strategy would be profitable in that case. But probability is not working in your favor.

*A week later the market plunged and volatility went from the 2nd percentile to the 90th in 5 trading days. Needless to say, the straddle would have lost substantial sums of money in a short period of time. The puts and calls exploded in premium terms. Volatility percentile rankings would have helped determine if this strategy had acceptable odds for success.*

- Anyone can trade a straddle or strangle or any other options strategy from the long or short side. But doing the trade in the correct volatility environment will be a key determinant in success rates. A trader wants probability working for them, not against them.
- Buy low, sell high pertains to volatility levels too.
- Use volatility percentile rankings as a tool or gauge to screen for certain trade strategies. They can be used as a risk management tool as well.
- To short premium, consider doing so when volatility is high…above the 75 percentile. Remember, percentile rankings are only one tool. Just because volatility carries a low percentile rank, does not mean that it cannot go lower. High volatility can sometimes go higher as well.
- Moreover, even if you are fortunate enough to buy volatility in the lower percentile rankings, you still must deal with time decay issues and choosing the appropriate strike prices and strategy. Keep in mind that options are four dimensional instruments— it is not only the up and down movement in the underlying that matters, but time to expiration as well as volatility. It is more work—more plates to keep spinning, but the additional strategies available to options traders are worth the effort.

Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments and, because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for either a futures or swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles and only a portion of those funds should be devoted to any one trade because traders cannot expect to profit on every trade.

CME Group, the Globe Logo, CME, Globex, E-Mini, CME Direct, CME DataMine and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. All other trademarks are the property of their respective owners.

The information within this communication has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this communication are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and superseded by official CME, CBOT, NYMEX and COMEX rules. Current rules should be consulted in all cases concerning contract specifications.

Copyright © 2018 CME Group Inc. All rights reserved

David Lerman, the Senior Director of Education at CME Group, gives seminars and workshops to retail and institutional audiences focusing on risk management and trading using Equity Index futures and options.

Mr. Lerman is the author of *Exchange Traded Funds and E-mini Stock Index Futures *(published by John Wiley and Sons)*.*

Prior to joining the CME in 1988, Mr. Lerman traded futures and options on U.S. Treasury Bonds at the Chicago Board of Trade and was Senior Portfolio Manager at Zavanelli Portfolio Research. Mr. Lerman taught investment management at Harper College and has lectured at the Northwestern University Kellogg Graduate School of Management.