Why is using "Mean Reversion" a Sound Trading Technique?
❑ Mean reversion involves first identifying the range of what is to be measured (traded prices of the underlying, Implied Volatility, etc.) and then computing the central measure of tendency (Mean or Mode) of that range. By virtue of having a limited range, the range shows the upside/downside extremes relative to where the Mean/Mode is currently trading at.
❑ Mean reversion is a more scientific method of choosing buy and sell points than using pattern–recognition from time–based charts (Candlesticks, OHLC Bar, etc), as precise numerical values are derived from a known data series to identify the buy/sell values within defined limits, rather than trying to interpret price movements using patterns not directly computed using Implied Volatility as a direct input into the calculation.
Why does Implied Volatility Revert to its Mean?
Implied Volatility is defined as the volatility variable which when entered into an option pricing formula equates the current calculated theoretical price of the option to its market price.
Is the Option's IV, Skew & Kurtosis at its Extreme High or Extreme Low?
To measure extremes from the mean requires an indicator showing if the current value of any parameter (IV, Skew & Kurtosis) is closer to its minimum and maximum reached over a 52 week period.
– If you constructed a debit spread which needs IV to rise but the IV of the product has gone into the 0.90–1.00 range, IV failing to rise harms the debit spread.
– If you constructed a credit spread which needs IV to fall but the IV of the product has gone into the 0.90–1.00 range, IV making a higher high harms the credit spread.
❑ IV at the extreme low range 0.00–1.00 may make a lower low or fail to fall further. There is no signal that mean reversion has started until IV comes out of the extreme low range of 0.00–1.00 and rises up to mid–range area of 0.45–0.55.
– If you constructed a credit spread which needs IV to fall but the IV of the product has gone into the 0.00–0.10 range, IV failing to fall harms the credit spread.
– If you constructed a debit spread which needs IV to rise but the IV of the product has gone into the 0.00–0.10 range, IV making a lower low harms the debit spread.
❑ The range between 0.45-0.55 is the mid-range risk area, as IV flat-lining harms both a debit and credit spread.
– Choose another product to construct a debit/credit spread.
Using the Hi-Low Indicator for Skew:
❑ As the Hi-Low Indicator for Positive Skew moves towards +1, this signals that Positive Skew has become larger. The larger the Positive Skew, the more frequent price is likely to drop to test Support levels, which has different implications on a spread's directional/non–directional bias.
❑ As the Hi-Low Indicator for Positive Skew moves towards 0, this signals that Positive Skew has become smaller. The smaller the Positive Skew, the less frequent price is likely to drop to test Support levels, which which has different implications on a spread's directional/non–directional bias.
❑ As the Hi-Low Indicator for Negative Skew moves towards –1, this signals that Negative Skew has become larger. The larger the Negative Skew, the more frequent price is likely to rise to test Resistance levels, which has different implications on a spread's directional/non–directional bias.
❑ As the Hi-Low Indicator for Negative Skew moves towards 0, this signals that Negative Skew has become smaller. The smaller the Negative Skew, the less frequent price is likely to rise to test Resistance levels, which has different implications for different spread types.
Home Options Trading chooses to dispense with the use of Kurtosis, namely as Kurtosis suggests that options remain underpriced/overpriced. Still, it's available within iVolatility's "Advanced Historical Data" service.