The implied volatility Z-score is a way of framing implied volatility in context. For example, today SPY closed up 0.35%, which is decent but nothing compared with some of the candles over the past few months. But how normal or abnormal is it? We don’t know unless we’re able to put it in context.
The current VIX hovers around 24, putting it well above the long run average of 14.7 (the line I drew is the current support line which also lines up with several spike highs in 2019).
So how do we measure how abnormal a value of 24 is? That’s what Z-scores do.
By the way this concept is discussed in much detail in the Options 101 course. Using IV Percentile or implied volatility percentile can be confusing as it differs between the TOS platform and the Tasty Trade platform. The IV Z-score uses the tried and true method of using a Z-Score to measure volatility.
Quick And Dirty Z-Score Refresher
If you’re new to Z-Scores, and have no idea what they mean, don’t be panic. Z-scores are super simple.
A Z-Score measures anything, rain levels, the number of people using outhouses at Burning Man per hour and the implied volatility of our favorite stocks. It works by measuring:
- Everything relative to the mean or average and…
- Measuring how far something is from the mean in standard deviations.
Sounds geeky? Yes, because it is. But once you use it, I’m confident you’ll be semi-pro with it in 5 minutes.
For example, let’s say we’re measuring how many people are using our favorite port-o-potty at Burning Man and discover on average it’s 30 people per hour.
At peak times, it’s up to 55 and during lulls at dawn, it’s only 5 people per hour. We do a bunch of number crunching and determine that the mean number of people using the port-o-potty is 30 people per hour with a standard deviation of +/- 10 people per hour.
The formula for computing a Z-score is super simple:
After we have our mean and the standard deviation, we can measure our data and give it Z-scores.
So if we stand there for five hours are count how many people per hour are using the port-o-potty, we can put the data in a Z-score context. After counting the people using our favorite bathroom away from home for five hours, our data looks like this.
If we pick the first row, 13, we get a Z-Score of:
(13 – 30)/10 = -1.7
The Z-Score gives us context to our data. If we look at our 8-9am slot, we can see there are 40 people using our favorite desert throne. Is that a lot or a little? With a Z-score of 1.0, we can see that 40 people using it is a lot.
Likewise, at 4-5 AM, we see we have 13 people using the port-o-potty with a Z-score or -1.7. That tells us that is abnormally low. For a Z-score, a normal range is 0 +/- 1.0. Anything above or below that is abnormal.
But enough about port-o-potties, let’s put our newly gained superpowers to the test. Shown above you’ll find the SPX on the top panel and the IV-Z score on the bottom. It’s very important to note that we are not looking at the Z-Score of the actual SPX here but the Z-Score of it’s implied volatility.
Subtle but important difference.
Implied volatility shows us directly (and not implicitly) how investors and traders perceive forward risk. Once again my wording is intentional in that implied volatility produced by some math geeks hidden away in Goldman Sachs’ basement – rather it’s a result of options being priced by active real world participants.
Note how the IVZ-Score remained below it’s long term median (near 0) throughout the latter part of 2019 during which expected move (once again based on implied volatility) was observed 23 weeks in a row.
Then suddenly all hell broke loose…
[MM_Member_Decision membershipId='(2|3)’] What followed next – as you well know – was a period of chaos and confusion which to no surprise punched IVZ-Scores across the board to the max.Things have normalized quite a bit since late March but it took over eight months for the IVZ-Score to dip back below the zero mark, which I consider traditional bull market territory, despite the fact that the VIX is still gyrating way above its 20 mark.
IVTS – the implied volatility term structure also has been normalizing and is currently at its 0.91 threshold – which for Tony and I is an important market. We’ve run exhaustive statistics on implied volatility and have come to the conclusion that anything at or below 0.92 is bull market territory and ideal for trading mean reversion on implied volatility ETFs, e.g. VXX, UVXY, SVXY, etc.
The big thorn in my eye however remains to be VX product depth for the remainder of the year. To add to the confusion it’s also often referred to as the VX term structure. Be this as it may that big hump for October has not budged which makes it clear that VX traders are anticipating a 2nd wave of volatility during early to mid fall.
This may also be the reason why the VIX has not dropped below its 20 mark and most likely won’t be able to do so until after the 2020 presidential elections are completely over (which may take longer than we think given what’s unfolding politically).
Another day – another high in my ‘monsters of tech’ composite symbol. What else is new? Well what stands out to me is that its IVZ-Score has never recovered back to its 2019 levels. I spoke about this the other day and my conclusion was that we are most likely looking at a late stage HV bull market.
When will it break? Hell if I knew… 😉
Things are getting a bit more quiet on the XLP front which also is highly interesting.
Why? Well, it’s always been a nervous bugger and after the early 2020 sh…tstorm subsided things are outright tranquil now as its IVZ-Score has completely flatlined. A prosperous future awaits for consumer staples? We shall see… but for now it’s a hell of a LV bull market.
One last example is XLF – financials. Not looking so hot there are they? Could be worse – like the Dollar – but financials have been meandering sideways for months now with no bids in sight. If you ask me, should there ever be a bear market on the horizon this is the one to short into submission.
Oh and its IVZ-Score also portends quiet times ahead, but with a sideways drift don’t expect any big moves anytime soon. Great sector for playing expected move however as I don’t expect any big surprises outside of earnings.
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