Thread by @MrJGBanks

📚Options Rule of 16

A thread on the Must Know "Rule of 16"

✅ What is it?

✅ How can I use it?

✅ How can I use it to buy favorable contracts using @unusual_whales

#OptionsTrading #UnusualWhales

No matter how you utilize options, the “Rule of 16” is critical for analyzing volatility, particularly for short-term options. Volatility is at the root of all options pricing. It is based on the statistical concept of standard deviation.

Standard deviation which measures the dispersion of a security’s returns around its average. Stocks move up and down during each trading day, and one with larger up and down daily price moves would have a higher standard deviation.

The dispersion of daily price movements, measured in % terms over a period of time, is the basis of the concept of volatility.
Implied volatility is a commonly discussed and observed statistic, with many vendors and brokerage platforms displaying it alongside options prices.

There are two features of implied volatility that tend to be poorly understood. First, it is a derived number – it is the last variable remaining in an options pricing model after accounting for the stock’s price, the option’s striking price and time to expiration...cont.

the stock’s expected dividends before expiration, and prevailing interest rates over the life of the option. Second, it is typically expressed in annualized terms. This where the Rule of 16 comes into play.

The $VIX was introduced by the Cboe in 1993 as a weighted measure of the implied volatility (IV) of the S&P 100 Index. In 2003, the VIX expanded to measure the S&P 500 Index (SPX). The VIX quickly evolved into the preeminent measure of investor fear and overall market volatility.

The $VIX is the IV of the $SPX. Let me simplify an interesting aspect of the $VIX: the number 16 is approximately the square root of 252 (the number of trading days in a year). This is where the rule of 16 comes from.

While you let that sink in, let’s walk through some hypotheticals. If the $VIX is trading at 16, then 68.2% (or two-thirds) of the time, it might trade up or down by less than 1%. The other 31.8% (or one-third) of the time, the $SPX might trade up or down by more than 1%.

Now let’s go further. The $VIX at 24 might equate to a 1.5% move in the $SPX 31.8% (one-third) of the time. A $VIX at 32 might equate to a 2% move in the $SPX 31.8% (one-third) of the time.

This is because we are dividing the $VIX by 16.

The options rule of 16 works the other way, too—you can “annualize" a daily reading by multiplying it by 16. For example, suppose a stock has had a few moves of 1.8%, and you think a 1.8% daily move might be typical in the near future.

If so, you would be expecting an annualized volatility level of 1.8 X 16 = 28.8%. Comparing your expectation to the current IV might indicate whether you believe an option is overpriced, underpriced, or fairly priced.

Examples on how to use the "Rule of 16" while using @unusual_whales

First we need to go to unusualwhales.com

Next I click "Flow" "Live Flow" and "Filters" I have highlighted in red below

Cont.

Next I put the ticker I want to look at. Let me use $AAPL for this example and since $AAPL is a Large cap I like to set Premium to $100k+. You can use whatever works best for your strategy.

Once we find a chain we like we want to look at the IV or "Implied Volatility"

This contract caught my eye. What this is showing is the market is anticipating that $AAPL will have annualized movement over the next 41 days of about 40%. Unfortunately, an annualized measure is essentially meaningless to holders of an option that expires in about a month.

The Rule of 16 is what allows us to place that implied volatility (IV) reading of 40% into a meaningful context.

There is a simple method for converting annualized volatility into daily volatility. We do this by dividing the IV by 16

40% / 16 = 2.5%

This means that the options market is anticipating that $AAPL will have an average daily up or down price movement of about 2.5% per day over the life of the option. (41 days) With $AAPL trading at $163.98, that is roughly $4.

It is far easier to visualize $AAPL moving up or down an average of $4 a day over the next 41 days. Those who think that the market is understating the daily price movement should consider buying options at that current volatility level. Opposite viewpoint should avoid buying.

Key Takeaways:

- Divide the $VIX by 16 to understand implied daily move of $SPX

- Divide an IV of an options contract by 16 to understand implied daily move of the life of the contract

- The Rule of 16 states the move will happen 1/3 of the time

I hope you have enjoyed this thread! Be sure to check out @unusual_whales and unusualwhales.com for more information and to improve your trading!