TT - MM: Standard Deviation and IV, 8/12/13

TastyTrade - Market Measures

What is Implied Volatility? IV represents a 1 Standard Deviation move (1SD) in the underlying for the next year.

A 1SD move encompasses 68.2% of all occurrences, which is 34.1% in either direction. Likewise, a 2SD move covers 95.4% of occurrences (13.6+34.1+34.1+13.6), and a 3SD move covers 99.7%. This is known as the 68-95-99.7 Rule, or the three sigma rule.

With a directional biased trade that covers a 1SD move we need to trade the 84% OTM option since we only concerned with movement against us.

To cover a 1SD move with a strangle or iron condor requires an 84% OTM call and put. The resulting probability is then 68.2% OTM.

Implied volatility can be used to calculate an expected 1SD move in an underlying.

• % Move = Vol / Square Root of (365/DTE)
• or % Move = (Square Root of DTE) * Vol / 19.1

You can see that if vol is 19.1 then the expected overnight move is 1%.