Introduction to the Volatility Cone

The volatility cone is a powerful tool in options trading that helps traders identify whether implied volatility is overvalued or undervalued compared to historical volatility. It is derived from the historical distribution of implied volatilities at different time frames, forming a cone-like shape when plotted on a graph. This concept allows traders to make informed decisions on volatility-based trading strategies.

In this article, we will explore what a volatility cone is, how it is constructed, and various trading strategies that can be employed based on its insights.

Understanding the Volatility Cone

A volatility cone is a graphical representation of the implied volatility of options across various expiration dates compared to historical volatility ranges. It is used to determine whether current implied volatility is expensive or cheap relative to its historical levels.

Construction of the Volatility Cone

  1. Collecting Data: The first step in constructing a volatility cone is to gather historical implied volatility data for different time frames (e.g., 30 days, 60 days, 90 days, etc.).
  2. Calculating Percentiles: For each time frame, historical implied volatilities are analyzed to determine their percentiles (e.g., 10th, 25th, 50th, 75th, and 90th percentiles).
  3. Plotting the Cone: When plotted on a graph, the percentiles create a cone-like structure where the x-axis represents time to expiration and the y-axis represents volatility.

This cone helps traders visually compare the current implied volatility against historical levels and decide whether options are expensive or cheap.

Interpreting the Volatility Cone

  • If current implied volatility is above the 90th percentile of the historical range, options may be considered expensive, making it an attractive environment for selling options.
  • If current implied volatility is below the 10th percentile, options are relatively cheap, making it a potential opportunity to buy options.
  • If implied volatility is within the 50th percentile range, it suggests that current volatility is fairly valued relative to historical norms.

Trading Strategies Using the Volatility Cone

1. Selling Options When Implied Volatility is High

Strategy: Selling Straddles or Strangles

When implied volatility is in the 90th percentile or above, it suggests that options are expensive. Traders can take advantage of this by selling straddles or strangles.

  • Straddle: Selling an at-the-money call and an at-the-money put with the same expiration.
  • Strangle: Selling an out-of-the-money call and an out-of-the-money put with the same expiration.

Example: If a stock is trading at $100 and implied volatility is at the 95th percentile, a trader could sell a $100 call and a $100 put. If volatility reverts to the mean, both options will lose value, generating profits.

Strategy: Iron Condor

This involves selling a strangle but hedging the position by purchasing further out-of-the-money options. It profits when volatility contracts and price stays within a range.

2. Buying Options When Implied Volatility is Low

Strategy: Long Straddle or Strangle

When implied volatility is below the 10th percentile, options are cheap. Traders can buy straddles or strangles to profit from potential volatility spikes.

Example: If a stock is trading at $100 and implied volatility is at the 5th percentile, a trader can buy a $100 call and a $100 put. If volatility increases, one of the options will gain significantly.

Strategy: Long Vega Trades

Vega measures an option’s sensitivity to changes in implied volatility. When volatility is unusually low, traders can buy options with high vega, such as long-dated options or LEAPS (Long-Term Equity Anticipation Securities).

3. Trading Volatility Mean Reversion

Since volatility tends to mean revert, traders can use this principle to sell volatility when it is high and buy volatility when it is low.

Strategy: Calendar Spreads

A calendar spread involves buying a long-term option and selling a short-term option of the same strike price. This strategy benefits when short-term volatility is high compared to long-term volatility.

Example: If 30-day implied volatility is at the 95th percentile but 90-day implied volatility is at the 50th percentile, a trader can sell a near-term option and buy a longer-term option to take advantage of the expected mean reversion.

Strategy: Ratio Spreads

Ratio spreads involve selling more options than are bought, such as selling two calls and buying one call at a higher strike. This benefits from high volatility selling while limiting risk.

4. Hedging Using Volatility Cone Insights

Hedging can be optimized using the volatility cone to protect portfolios against adverse movements.

Strategy: Protective Puts

If implied volatility is low, long puts can be purchased to hedge downside risk at a lower cost.

Example: If a trader owns shares and volatility is at the 10th percentile, buying puts provides cheap insurance against a market drop.

Strategy: Dynamic Hedging with VIX Products

Traders can use VIX futures and options to hedge against rising volatility when the volatility cone suggests an increase.

5. Advanced Strategies Combining Volatility Cone with Other Indicators

Strategy: Combining with Bollinger Bands

  • If implied volatility is high and the stock is near the upper Bollinger Band, it may signal a short opportunity.
  • If implied volatility is low and the stock is near the lower Bollinger Band, it may signal a buying opportunity.

Strategy: Pairing with Open Interest and Volume Analysis

  • High open interest with high implied volatility may suggest excessive speculation and a potential volatility crush.
  • Low open interest with low implied volatility may suggest an impending volatility expansion.

Conclusion

The volatility cone is a valuable tool for options traders, offering insights into whether options are overvalued or undervalued relative to historical data. By using this information, traders can design strategies that capitalize on volatility mean reversion, premium selling, or hedging opportunities.

Understanding and implementing strategies such as selling options when implied volatility is high, buying options when it is low, using calendar spreads, and hedging effectively can significantly improve trading performance. By combining the volatility cone with other technical indicators, traders can further refine their edge in the market.

Consistently applying these strategies requires discipline, risk management, and a keen understanding of market behavior. Traders who integrate the volatility cone into their analysis can enhance their ability to make informed and profitable trading decisions.