Traders love IV Rank. But are you relying too much on it?
The IV rank is a popular metric for many traders due to the fact that it can help them assess whether options are relatively expensive or cheap. Increased volatility leads to higher prices, and lower volatility results in lower prices. If you can get a measure of how the current volatility compares to its historical highs and lows, you can gain insights into the present stock price being higher or lower than usual. It’s a good way to find out when the appropriate time is to enter or exit trades.
However, overusing IV rank in your trading plan can be potentially misleading, especially when used alone and not in conjunction with other technical indicators. Some issues arise when not taking the full market context into account and using IV rank as your sole source of information to base your trading plan around.
You can’t assume that IV rank will always tell you when options will be overvalued. Our guide will show you what IV rank doesn’t tell you—and how to spot better trades.
Quick Refresher—What IV Rank Measures
IV Rank is a metric that options traders can use to measure a stock’s current implied volatility relative to its historical range over a specific period. The IV rank is presented as a percentage (somewhere between 0 and 100), and it usually measures historical implied volatility over the course of a year (most of the time). IV rank basically shows a comparison between the current IV level and how that compares to the historical highs and lows it has experienced in the past.
IV Rank Values
Values that are between 0 and 100 represent the relative positions of the current implied volatility levels within the historical range. On one end of the spectrum, you have 0, which represents the current IV at its lowest level within the observed year. On the other side, it has the IV rank of 100, which is the current IV at its highest level within the observed year.
Simple Example of IV Rank
An IV rank of 70% would mean that 70% of the time over the past year the underlying asset was lower than its current level. This IV rank suggests that the market is expecting more price fluctuation than it has in the past years. This could be due to upcoming news or events, but what that could be specifically is all based on the current context. That’s why it’s important to be following current events and relevant market news to get these insights.
Strengths of IV Rank
On top of IV rank giving relative volatility context and helping traders to spot premium-selling setups, there are several other strengths that come with including IV rank as a technical indicator into your current trading plan.
- Strategic Decisions: IV rank can be an instrumental metric in helping traders decide which options strategies they should be using. Low IV rank can show that buying options is preferable, like long calls or puts, while high IV rank is a sign to sell options with strategies like iron condors or credit spreads.
- Understanding the Risks: High IV rank is a good sign of options being more expensive than usual, which is a decent indicator that there’s going to be higher volatility and increased risk in those trades. On the other hand, low IV rank presents the exact opposite: the potential for lower risk.
- Understanding Market Conditions: Having a reading of the historical implied volatility rates from prior years can offer traders insights into whether or not the current stock prices are overvalued or undervalued. In these instances, a high IV rank would represent an overvaluation, while a low IV rank would signal an undervaluation.
- Gain an Edge: Traders using IV rank as a technical indicator in their trading plan can achieve an edge or advantage in the options market. It’s a useful tool that can ensure traders are entering traders at the best prices. It greatly improves profit margins over time, if done correctly.
- Adjust Your Positions Effectively: If there’s a decline in implied volatility after you sell options, it could be a sign of an opportunity to close the position early to lock in a good profit. On the other hand, IV rank can be used to take profit after the trader witnesses an increase after they buy.
Limitations of IV Rank
- Doesn’t Always Predict Correctly: IV rank can be used to get a rough prediction of future price movements, but it’s not a guarantee that those price movements will happen.
- Look Out For Skews Following High IV: You typically see IV rank lower for almost all levels of IV in the future following a period of abnormally high IV. However, it’s important to look at the big picture here. Those lower levels might still be relatively high in their historical context. You have to keep this in mind to get accurate readings and understand the situation.
- IV Rank Isn’t a Frequency Indicator: IV rank won’t show how often the IV was below that level, but only show where the current IV falls within the past year’s range.
- Extreme IV Spikes: IV rank might remain high following an event where there’s an extreme increase in implied volatility. This lag occurs even after the IV returns to its more normal levels.
- Changes in the Fundamentals: IV rank doesn’t always take into consideration any fundamental changes which might occur in the risk profile or business model of a company, which can present a severe limitation with using this indicator in any trading plan.
The Problem—What IV Rank Leaves Out
With an idea of the limitations that come with IV rank, let’s dive into some of the key things that IV rank leaves out when it’s used in isolation. Remember IV rank can be highly useful to options traders, but it needs to be used with other technical indicators for confirmation, and the wider market context also needs to be taken into account. Keep these issues with IV rank in mind before working it into your trading plan!
𐄂 Doesn’t Show Directional Bias
High IV Rank doesn’t tell you if calls or puts are driving it. IV rank only focuses on relative volatility levels, specifically when the current IV sits at its historical levels. Now, traders could assume that a high IV is a sign of bullish sentiment, but this is where they could get into trouble if they don’t cross-check it with other indicators or don’t keep up to date on market news or events.
𐄂 Ignores IV Skew and Smile
IV rank also ignores skews and smiles on the chart because it’s focused on the current IV levels relative to their historical averages. Skew between strikes is crucial for strategy selection, and IV rank doesn’t offer this insight to traders, unfortunately.
𐄂 Historical Volatility Is Missing
There are times when IV rank can appear to be inaccurate or missing data, and this is likely due to data sets being updated or that the data used to calculate the rank aren’t currently available. The source of these problems could range from platform updates and temporary glitches in data feedback to factors like the stock not having enough trading history to get a correct calculation of IV. When there’s no comparison between implied and actual market movement due to these problems, this is where IV rank can fall short.
𐄂 No Context of Market Environment
IV rank could be pointing to certain patterns with the stock prices, but it never takes into consideration macro events, earnings, or Fed decisions that can have a large impact on the stock prices. Because IV rank doesn’t take the market environment into consideration, it’s a technical indicator that can come across as misleading, that is, unless it’s coupled with other indicators to form a clear picture.
𐄂 Lacks Real-Time Dynamics
IV rank can severely lag behind rapid volatility changes, especially if you’re dealing with unexpected shifts in market sentiment or price, as well as sudden underlying asset changes. IV rank doesn’t always keep up with these major changes and results in some lag time between the two realities.
Case Study—When IV Rank Led Traders Astray
As we’ve mentioned a few times, IV rank can be a dangerous metric to center an entire trading plan on because there are so many limitations with it, especially if you’re not using other indicators or you’re not considering the full market context. Some of the biggest mistakes that have been made by traders using IV rank is making assumptions. We’ll dive into this idea further in the example below, and how it can spell disaster for inexperienced or overly trusting traders.
Example of High IV Rank Setup That Failed
It can be easy to assume that, when IV rank is high, it’s preferable to buy put options because you’re assuming that the stock prices are bound to turn around and eventually drop once volatility settles down. However, there’s a scenario where other traders could rally around the stock and force the price even higher, which would make the trader who assumed the price would drop lose money on the put option they set up.
Using Other Data Points for Cross-Reference
As mentioned a few times already, it’s key for traders to use IV rank along with other dates to paint a clearer picture. This would include other indicators, including the following:
- IV Skew — This indicator measures the difference in implied volatility between out-of-the-money calls and puts. Skew can offer insights on which are more volatile at the moment: call options or put options. Positive skews, associated with OTM puts, are associated with bearish market sentiment. Negative skews signal bullish sentiment and are more common with OTM calls.
- Historical Volatility — This indicator takes IV rank a step deeper and quantifies how much the past price movements have varied, a measure of how much the price has changed from its average. It implies a greater chance of large price swings either upward or downward. Pairing this one with an IV rank can offer better insights into the current situation and the best course of action from there.
- News — While it’s not technically an indicator, we wanted to include news and any relevant market events in the mix here to show its ultimate importance in providing the correct context for the trader. IV rank offers good insights, but it has too many limitations to be taken at face value. Using news events to inform what you’re seeing with IV rank can develop a clearer picture of what’s happening.
How to Fill in the Gaps—Tools Smart Traders Use
This section in our guide will go over the other tools you can be using to close the gaps that IV rank and its limitations create. Make sure your trading plan has no major holes and begin working some of these tools into your trading sessions to use IV rank to the best of its ability.
✓ IV Percentile vs. Rank
IV percentile shows what percentage of days in the past year that the IV was lower than its current value. Using percentile provides better insight in volatile or sideways markets, some instances where IV rank generally falls short. It provides some context by showing how often IV trades below current levels, while IV ranks simply shows if the current level is high or low relative to the range being studied.
✓ IV Skew Analysis
IV skew can be used to see where market expectations and sentiment are regarding potential price movements with the underlying asset. Check which side of the chain is rich (calls vs. puts). Negative skews are typical for higher IV for OTM puts compared to OTM calls, which indicates a bearish outlook. Positive skews are the exact opposite. They signal higher IV for OTM calls than for OTM puts or bullish outlook.
✓ Compare Implied vs. Historical Volatility
Historical volatility is a backward-looking measure to see what volatility levels have been like in the past, while implied volatility is a forward-looking measure that tries to predict how volatile the market will be in the future. Using both together can provide traders with some key insights, specifically mean-reverting opportunities where any volatility that happens in the future could possibly go back to its historical levels once the uncertainty in the markets has cleared up.
✓ Check Event Calendar
Another great way to plug the gaps that are left by IV rank and its limitations is to look at event calendars to stay on top of things like earnings reports, product launches, or Fed announcements. You can’t predict everything that is going to happen like breaking news that was completely unexpected or black swan events, but you can plan around the events that have already been announced. You can count on events like this to see some upticks in the volatility levels, but volatility generally reverts to its mean once the events are past.
✓ Use Multi-Timeframe Analysis
Pairing IV rank with multi-timeframe analysis allows traders to assess the overall market trend and the specific volatility context that’s occurring with the underlying asset. High IV Rank on a daily chart might look very different on a 1-year weekly, which is why it’s a good idea to analyze charts across different timeframes.
Best Practices—Making IV Rank Part of a Bigger Picture
Treat IV rank as a signal, not a decision-maker. Remember that it’s best used alongside other technical indicators and relevant market news. To make the best of IV rank and work it into the bigger picture of your trading plan, be sure to combine this technical indicator with the following things:
- A Suitable Strategy—Credit and debit spreads are both good options when it comes to integrating IV rank into your trading plan. Credit spreads are a good move if you’re interested in taking advantage of decreasing IV, while debit spreads are a better fit for scenarios where you have increasing IV.
- The Right Market Conditions—If you’re interested in making a profit on the relative expensiveness or cheapness of option premiums, your best bet is to use IV rank in market conditions where volatility is to be expected. Not only that, but it’s market conditions where volatility is expected to revert to its mean over time.
- Risk Tolerance—Depending on how much you’re willing to take on new risks, you might like the idea of selling options when the IV rank is high (high volatility conditions). While these investments are more risky, they can provide bigger payouts than low IV rank scenarios. With low volatility environments, you’re dealing with lower option premiums, but you’re more likely to have your trade be successful, though the pay would be much smaller.
- Position Sizing—IV rank can influence a trader’s position size as well, so it’s another consideration to think about when working IV rank into your bigger strategy. It could be a good idea to use a smaller position size (perhaps 1% of your total capital) if you’re buying options while the IV rank is high. Or you could use a larger position when selling like 2% to capture the high premiums.
If you’re looking for good IV rank tools to gain insights into historical levels of implied volatility, we’d recommend using platforms like ThinkorSwim or Market Chameleon, which offer robust IV rank tools.
Final Thought—Don’t Trade in the Dark
Smart traders see the entire picture. When it comes to using IV rank as a technical indicator in options trading, it’s best to use other indicators for confirmation of the trends you’re seeing, as well as taking the entire market context into account. Don’t fall for the fallacy that IV rank is all you need to make the best trading decisions around volatility—IV rank is just the beginning!
Key Takeaways
Remember these key principles in using IV rank in your trading plan, so you don’t end up “trading in the dark.”
- IV Rank is helpful but incomplete.
- It doesn’t account for real-time volatility shifts, skew, or market events.
- Fill in the gaps using tools like IV skew charts, HV comparisons, and event tracking.
- Combine data for smarter, more confident trades.
- Always match strategy to volatility conditions, not just rank.
