Yo Pit Crazies,

A student asked me last week how I know if options are cheap or expensive. Not “the option looks expensive” based on gut feel. Actually cheap or expensive relative to what the stock is doing.

The answer is the Rule of 16, and it’s the simplest volatility calculation you’ll ever learn.

Take a stock’s average daily move (you can use ATR, average true range, which every charting platform shows). Multiply by 16. That gives you annualized volatility. Why 16? It’s close to the square root of 252 (the number of trading days in a year), rounded for easy math. Schwab’s research confirms this: “According to the rule of 16, if the VIX is trading at 16, then the SPX is estimated to see average daily moves up or down of one percent.”

The Quick Calculation

Pull up ATR on any stock. Let’s say it’s showing $4 on a $200 stock. That’s a two percent daily move. Multiply by 16 and you get 32 percent annualized realized volatility.

Now look at the implied volatility on the options. If IV is 25 percent, the options are cheap relative to how the stock is actually moving. If IV is 45 percent, the options are expensive.

I did this calculation on AVGO recently. The stock was showing about 60 realized volatility based on ATR, but options were pricing 43 implied. That’s a 17-point gap. The options were cheap.

From Vibes to Framework

Most retail traders look at absolute option prices. “This call costs $5, that seems expensive.” That’s not analysis. That’s vibes.

The Rule of 16 gives you a framework. If realized vol (what the stock is actually doing) is higher than implied vol (what options are pricing), you want to be a buyer of options. If realized is lower than implied, you want to be a seller. It’s not foolproof, but it’s a starting point, which is more than most traders have.

Next trade: pull up ATR, divide by stock price, multiply by 16, compare to IV. Takes 10 seconds. Tells you whether you’re buying cheap or expensive options. That’s edge.

Andrew