In my Wednesday post I introduced the Z-Score and also explained how we use it for scoring implied volatility, making it the IVZ-Score. What I didn’t focus on much is why one would do such a thing in the first place, and the underlying purpose may not be immediately apparent to some. Now I already can sense your eyes glazing over plus it’s Friday, so I’ll promise to make this brief and actionable for non-nonsense traders mainly interesting in turning a buck.

As I’m a visual guy I always enjoy plotting things as opposed to just looking at a set of numbers. Since I understand basic algebra however an IVZ-Score of let’s say 1.5  does tell me quite a bit about how to interpret risk pricing of a particular asset.

Tony and I have run the numbers and do know how to shift our strategies should AAPL for example push to an IVZ-Score of 2.5 – or minus 2.5 (which obviously happens a lot more rarely). But what if it AAPL pushes all the way to an IVZ-Score of 4.2 – what does that mean to us?

Well, the stats actually suggest that anything beyond an IVZ-Score of 2 usually results in mean reversion before the EOW – under normal circumstances. Clearly it’s not something we saw during the February wipeout during which we saw wide swaths of symbols push into an IVZ-Score of 4 and above.

The Problem

The issue we are facing here is one of context – which is a common affliction when it comes to interpreting implied volatility. Statistically speaking what is the difference between an IVZ-Score of 3 and an IVZ-Score of 6? Should we try a mean reversion trade starting at 3 or at 4, or perhaps wait for 6 – should it ever arrive?

A Possible Solution

One of my intrepid readers and part time quant who calls himself ‘Bob The Horse’ sent me a sweet little mathematical nugget I decided to put to the test. The basic idea of his adjusted formula is to create a bound range between -100 and 100 which can be more easily interpreted as it aims to convey statistical probability.

Before I share the formula let’s just look at both our good old vanilla IVZ-Score in the bottom panel in comparison with what henceforth shall be known as the BIVZ-Score in the middle panel – which either stands for ‘Bound IVZ-Score’ or ‘Bob’s IVZ-Score’ to honor its creator.

What immediately becomes apparent from plotting the signal is that there is not much difference between an IVZ-Score of +4 and +6. And that makes complete sense if we reflect on the fact that there never is such a thing as an ‘overbought’ or ‘oversold’ market. Like a stochastic or a MACD implied volatility seems to become ’embedded’ once it reaches a threshold of 90% or above.

This is a lesson I had to learn the hard way back as a fledgling trader and seeing it as a simple graph is hugely helpful, at least in my book. Now before we move on to a few more examples let’s take a look at the formula:

[MM_Member_Decision membershipId='(2|3)’] Which is rather trivial – all that’s required is a Z-Score, Euler’s Number (a.k.a. the natural log), and a bit of algebra. Let’s use an example IVZ-Score of 1.5:

Step 1: Take the IVZ-Score exponent of Euler’s #:

2.7183 ^ 1.5 = 4.4817

Step 2: Take that number and divide it by the same number + 1:

4.4817 / (4.4817 + 1) = 0.8176

Step 3: Deduct 0.5:

0.8176 – 0.5 = 0.3176

Step 4: Multiply that number by 200:

0.3176  * 200 = 63.515

And there you have it – a bound IVZ-Score! 🙂

Now let’s take a look at my monsters of tech compound index in addition to our newly minted BIVZ-Score. Once again it shows us that high IV does not necessarily mean an instant reversal. As a matter of fact it seems a medium to long term floor is not in place until the signal drops below the 75 mark.

The regular IVZ-Score however falls a lot more quickly and could easily give us the impression that – statistically speaking – a floor should be in place. Now personally I do understand implied volatility well enough to grasp the meaning of a 4 std deviation vs a 2 std deviation. But plotting it within a bounded range makes it a lot more obvious and is rather educational I’d say.

Now let’s go really crazy and try this thing on TSLA. Boy oh boy – Elon Musk seems to eat implied volatility for breakfast. What I find particularly interesting here is how IV was rather elevated back in July during an exhaustion spike and then remained high for almost a month.

Since then TSLA has recovered and then some but with a very muted BIVZ-Score, which tells me that at least for now this run may have legs. If I was long here (and I’m not) I would hold strong until I saw the BIVZ-Score punch significantly higher. And if you’re thinking of shorting this rally then the BIVZ tells you to hold your horses (Bob’s or anyone else’s) and wait a little longer.

[/MM_Member_Decision] [MM_Member_Decision membershipId=’!(2|3)’] Please log into your RPQ membership in order to view the rest of this post. Not a member yet? Click here to learn more about how Red Pill Quants can help you advance your trading to the next level.
[/MM_Member_Decision] [MM_Member_Decision isMember=’false’] Please log into your RPQ membership in order to view the rest of this post. Not a member yet? Click here to learn more about how Red Pill Quants can help you advance your trading to the next level.
[/MM_Member_Decision]