Test 7: IV/HV

I thought it would be fun today to test whether it makes sense to use implied volatility as an entry criteria to our tests. Specifically, I am looking at whether the ratio of IV to HV (historic vol) will be beneficial.

I’ve heard that generally speaking it is a bad practice to sell premium when the HV is larger than the IV. We like to sell in high IV environments with less underlying movement (actually that is ideal). When IV is lower than HV, can we get enough premium to justify the potential large swings in the underlying? We are actually under that situation right now with the VIX at 13.49.

For this test, I construct rules that only allow trades to be entered when the IV/HV ratio is greater than (1.0, 1.1, 1.25, 1.5, 1.75, and 2.0). No other entry or exit parameters are used. Note that in this test I am only using the implied volatility of the front-month option chain calculated based on a weighted average of the ATM call and put IVs.

Results

1 Month 2 Months 3 Months All
Improved PF 9(17%) 38(70%) 38(70%) 85(52%)
Improved MaxDD 54(100%) 54(100%) 54(100%) 162(100%)
Improved ExpRet 9(17%) 38(70%) 38(70%) 85(52%)

The initial pass is interesting; the back months show a much higher benefit that the front month. The heatmap shows this in even more detail:

iv-heatmap-diffpf

The obvious conclusion is that if you find yourself with a 2x IV over HV, make the trade, but the data shows these are extremely rare (i.e. 6 trades in 9 years). Discounting these trades, we can see that generally speaking in the other cases using IV/HV as a marginal impact.

There are several trades that really stand out to me, all in the 2nd month. The 10-Delta, 15-Delta, and 18-Delta trades with IV/HV of 1.25 and 1.5 all saw at least 25 trades during this period and had substantial improvements. The 10-Delta 1.5 IV saw only winners. What is so special about this cluster of trades? Digging into the specific trades they show that they only have a few losses, but their neighbors have about the same number of trades and just 1 or 2 more losses. Those extra losses were enough to dramatically skew the results considering this is an expiration test and the losses were all max losses.

Now, what happens if we also include the early exit trigger from the previous test?

iv-style-heatmap

In this case we start to see pretty consistent and significant improvements in the back month trades. These are also fairly significant improvements over the early exit tests themselves. And note the cluster in the second month trades is no longer as significant.

Conclusion

On its own, the IV/HV ratio is not a great indicator to help enter trades. While there are scenarios where the ratio seems to help a great deal, these come at the cost of significantly less trades. However, it seems that paired with other triggers it may be more beneficial than not.

The higher the IV/HV ratio, the less number of trades that are going to occur. Is it worth it to wait until the IV is greater than the HV, in my opinion… yes if you are looking at back months. I am actually quite surprised that there was not a more dramatic effect for the front month since this test was using the front-month IV in its calculation. In the last 9 years there are only a few cases where the IV/HV ratio was less than one (i.e. HV greater than IV), and only one period where the HV was higher for sustained period of time.

Overall, I’m not convinced this tool is critical unless one is already in a low vol environment. If the HV is high, but the IV is also high, we would expect to be paid a decent premium and be able to get wider strikes, possibly nullifying the effect.

It is also interesting to note that the HV is a lagging indicator and the IV is a current sentiment indicator based on the market’s perception. Realized volatility in the past may not carry though to the time when HV is greater than IV. This would result in potentially missing trades good trades, and possibly allowing some bad ones.

Test Stats

Permutations 162
Profitable Scenarios 121 75%
Total Trades 7283
Profitable Trades 5212 72%
Expired 2442 34%
MaxDays 4841 66%
Test Duration 1.38(min)

Test Files

Excel Data

5 thoughts on “Test 7: IV/HV

  1. Great post. For a future test, consider evaluating how trades perform by IV level (independent of IV/HV ratio). For example, if you only took trades in the top / bottom 10% / 20% / 30% / … of IV rankings, how would you do.

    Also, you may have posted this somewhere already, but what is your universe for trades? All optionable symbols? Over what timeframe?

    Thank you.

  2. Note: After leaving the comment above, I read the “start here” post but wasn’t clear if this particular test was Iron Condors on all 2,200 symbols or just on the RUT since 1990. Thanks again for your post.

    • I only have the historical data for the RUT at the moment, and only back 9 years (I discovered errors in the data beyond nine years). Historical Option data is expensive and getting data for all securities is ummm… cost prohibitive for me. I take donations though 🙂

      I will likely add the SPX and possibly the NDX, AAPL, GOOG and AMZN at some point as I am very interested in how their volatility indexes can help manage the trades.

      Independent IV tests are next. I just had IV/HV on my brain due to the recent IV crush.

  3. Hi Dustin,
    You have a lot of interesting articles. I am also using options backtesting before trading any strategies. You seem to like iron condors and i prefer spreads or a trending side of iron condor. 🙂
    I also had problems finding a decent options backtester and built something with my team. Check out oscreener.com it also has screening and backtesting features. Looking forward to get your feedback.

    • Its not that I like iron condors more than anything else, but it helped be create the structure for the backtest code. I plan on adding more strategies soon (legged verticles, calendars, double calendars, collars, strangles, straddles and reverse condors are particularly interesting to me).

      I’ll check out your site soon. Actually saw it pop up on a google search the other day. Wish I had a team… 🙂

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s