[Options] I'm in the Mean Reversion Business

Sean McLaughlin
August 17, 2023

A reader recently reached out to me, asking about a trade I put on.

I’m paraphrasing, but the conversation went something like this:

Reader: “The implied volatility of the MSTR June 450 calls is 64.7%. That is far from cheap, no?”

Me: “The absolute number of implied volatility is meaningless to me. I’m paying attention to its relative value. I want to know where IV is now compared to where it’s been.”

Reader: “Wow. That amazes me. I always thought the implied volatility was an indication of how expensive an option was. Could you write an educational piece on this sometime please?”

Dear reader, your wish is my command.

Here’s the thing about options premiums (and implied volatility, or “IV,” which measures premiums) – they mean revert.

When IV spikes, it’s only a matter of time before it comes back down. And when IV is low, it’s likely that any sudden premium moves will be to the upside, not the downside.

Why is this true?

Because fear and greed drive options prices.

When investors are fearful, they are willing to bid up the prices of put options to protect their long stock investments or bid up the prices of call options to protect their short positions. This often occurs when a binary event (think earnings announcement, product release, etc.) is on the horizon and investors are worried about the event risk. This also happens (often too late) when surprise news or events hit a stock or the market and investors scramble for asset protection in an effort to minimize any further losses.

Meanwhile, when investors are greedy and want to take advantage of what they perceive to be a meaningful and perhaps underappreciated catalyst to drive a sudden change in the price of an underlying asset, they will bid up the cost of calls (if they’re bullish) or puts (if they’re bearish) to leverage into a swift and hopefully profitable move.

This is all well and good and normal.

Next, whatever news or event that was driving the rising premiums in options happens. Then, it gets further into the rearview mirror. The perceived risk fades away and market participants no longer feel exposed to any more risk that they need to protect themselves against. Or, whatever “news” happened just becomes the new normal going forward and we adjust. That’s what humans do. We adapt to the new environment. That’s true in trading and it’s true in life. How else could we live?

And so the “risk” fades and traders and investors who bought protection (or “insurance” if you prefer) look to sell their protection and this drives options premiums back to lower, more normal levels.

This happens time and time again.

Mean reversion in options prices is a given. Of course, it doesn’t always operate on a time schedule that accommodates my positioning.

But I can stack edges in my favor by positioning in options strategies that will benefit from a decline in premiums (think naked puts, bear call spreads, short strangles, etc.) when volatility is elevated – relative to where it’s been.

Conversely, when volatility is relatively low, I can bet that the next big move in options prices will be higher since it likely can’t go much lower.

Neither bet is fool-proof, but it is a reliably dependable edge that compounds in my favor over time.

In the end, it’s not the absolute number of the implied volatility score that matters to me, it’s the current score relative to where it’s been over the previous 6-12 months that matters most.

I cover this topic a bit more in a recent “Lunch & Learn” video I hosted on Stock Market Media. You can watch it here.

Trade 'em Well,

Sean McLaughlin
Chief Options Strategist
All Star Charts, Technical Analysis Research

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