Traders use the “Rule of 16” to easily convert “annualized volatility” into “daily volatility” and vice versa.
- Daily Volatility = Annualized Volatility /16
- Annualized Volatility = Daily Volatility x 16
Implied volatility, e.g., the VIX Index, is typically expressed in annualized terms. Unfortunately, an annualized volatility is essentially meaningless if you are a short-term option trader. The Rule of 16 is what allows you to place that annualized implied volatility quickly into a meaningful number.
Why the Rule of 16 works?
Because the NYSE and NASDAQ average about 252 trading days a year, the formulas to convert annualized volatility (e.g. the VIX Index) to daily volatility and vice versa are:
- Daily Volatility = Annualized Volatility / √ 252
- Annualized Volatility = Daily Volatility x √ 252
The square root √ 252 = 15.87 or approximately 16. Therefore, professional options traders use the quick and easy calculation and divide and multiply by 16.
Knowledge of the Rule of 16 makes it easy and intuitive
With the rule of 16, you can get a good sense of daily volatility even without a calculator. Just keep the table below in mind:
| Annualized volatility (e.g., VIX Index) | Daily volatility |
|---|---|
| 8 | 0.5% |
| 16 | 1% |
| 32 | 2% |
| 48 | 3% |
| 64 | 4% |
| 80 | 5% |
A daily volatility of 1% means that there is 68% probability (or approx. 2/3 of the time) for a daily price range of -1% to +1%, this is also called the “Daily Expected Move“. The probability for the daily price to trade up or down by more than 1% is approx. 1/3 of the time.