16 Minute Abs

Mat Cashman, Principal of Investor Education at the Options Clearing House, joins IBKR’s Jeff Praissman to discuss the Rule of 16 and how traders can use it in their analysis and decision making.

Summary – IBKR Podcasts Ep. 244

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hello everyone. Welcome to another episode of the Interactive Brokers Podcast, brought to you in partnership with the Options Industry Council and the OCC. I’m your host, Jeff Praissman. Today we’re lucky to have as our guest Mat Cashman, Principal of Investor Education at OCC. Mat, welcome. What are we going to discuss today? 

Mat Cashman 

Thanks, Jeff. It’s great to be here, as always. We are going to discuss the Rule of 16 today. We just wrapped up a webinar on this topic, but we’re going to use this as an opportunity to dive into it in a more conversational way. 

Jeff Praissman 

Yeah, absolutely. And it was a great webinar — I highly recommend our listeners go to our website and catch the replay if they weren’t able to join us live. So today we’ll be breaking down the Rule of 16 and how it helps traders interpret implied volatility on a daily level. But like we always do here on the podcast, we’ll take a more conversational deep dive. 

Mat Cashman 

That’s right. The webinar laid out the foundations, and I go into some real specifics about how the actual math works behind the scenes. But today, we can break it down a little further and explore how traders use this concept to inform their everyday decision-making. 

Jeff Praissman 

Sounds good. And Mat, let’s start with the basics. Implied volatility — or IV, as it’s usually referred to — is really one of the most important concepts in options pricing. At a high level, it represents the market’s expectations of future price movements. 

Here’s the catch: IV is quoted on an annualized basis. That means when we see an option with a 20% implied volatility, it really tells us the market expects a 20% move over the course of a year. But of course, options aren’t usually a year long. 

Mat Cashman 

Yeah, exactly. That’s where the two don’t necessarily line up. Most traders aren’t looking at a full-year time horizon, so they want to understand how much movement is being implied — maybe on a daily or weekly basis. And that’s where something like the Rule of 16 comes into play. 

Jeff Praissman 

So Mat, before we even break down the Rule of 16, I’d like to quickly touch on standard deviation, because it’s really a key piece of this. For our listeners — and probably a lot of them know this — but for those that don’t: in statistics, standard deviation tells us how much something typically deviates from its average over time. 

The same idea applies to market prices. One standard deviation represents a range within which prices are expected to move about 68% of the time. 

Mat Cashman 

That’s right. And when we’re dealing with implied volatility, we’re essentially using option pricing models to estimate the market’s expectation for future standard deviations of movement. So you’re thinking about how big that range is that covers that 68% of the prices over time. 

The tricky part here is converting that annualized volatility — because implied volatility is an annualized number — into something more practical that we can think about in terms of standard deviations on a daily basis. 

Jeff Praissman 

And that’s exactly where the Rule of 16 comes in. But I’m thinking to myself — there’s a scene in There’s Something About Mary where a guy is talking about “8-Minute Abs” and he comes up with “7-Minute Abs.” So I’m thinking — why 16? Why not 14? Why not 12? Why not 20? 

Mat Cashman 

I love that. So the number 16 comes from the fact that there are roughly 252 trading days in a year. And if you take the square root of 252, you get about 15.87 — which we round up to 16 for simplicity. It also just rolls off the tongue — the Rule of 16. 

But that means to estimate the expected daily movement of a stock, you essentially divide its annualized implied volatility by 16. That’s how we get to the daily standard deviation. 

Jeff Praissman 

So just to clarify for our listeners — if an option’s implied volatility is 20%, we’re going to divide that by 16, which gives us about 1.25% per day. 

So if the stock’s trading — let’s just say — at $100, that means the market is implying a $1.25 daily move on average. 

Mat Cashman 

Exactly. And the key insight here is that the Rule of 16 really allows traders to take an abstract annualized volatility — which we just talked about as not particularly relevant to our everyday lives — and turn that figure into something tangible and digestible on a daily basis. That’s really what we’re looking for here. 

Jeff Praissman 

And Mat, in your webinar you emphasized breaking down the formula into two structural parts — the numerator and the denominator. Can you explain that? 

Mat Cashman 

Sure. The numerator I like to think of as the big block of variance. It’s really the implied volatility multiplied by the stock price. 

So if you’re looking at an option that has — in our example — a 20% volatility and the stock is trading at $100, you would multiply those two things together and you’d get $20 of theoretical movement. But again — that’s an annual number. It represents the expected movement over the entire year. 

Now, the denominator is where we take that big annual expectation — that big block of variance — and slice it into smaller, more manageable pieces like daily, weekly, or monthly expectations that you can actually use on a daily basis. 

Jeff Praissman 

So by dividing by 16, we’re essentially chopping the annualized expectations into daily increments. 

But going back to my kind of whimsical question — does this concept only work for daily increments? Or can traders do the “7-Minute Abs” version? Can they use this logic for other time periods? 

Mat Cashman 

Oh, you can have 7-Minute Abs. You can have 8-Minute Abs. You can have 9-Minute Abs. And that’s a great analogy. 

Traders can absolutely extend this concept into different subsets of that annualized number. You can divide by the square root of 52 — why the square root of 52? Because there are 52 weeks in a year. The square root of 52 is about 7.21 — that gives you a weekly expectation from that annualized big block of variance. 

You could also divide by the square root of 12 — which is about 3.46 — and that’ll give you a monthly expectation for how much something might move over the course of a month based on that annualized variance. 

But the key here is that you’re really just slicing that big block of variance into different pieces depending on how much of it you want to look at at one point in time. 

Jeff Praissman 

Got it. Got it. And now that we’ve covered the logic, let’s talk about how traders can actually use the Rule of 16 in the real world for analysis and decision-making in their trading strategies. 

Mat Cashman 

Yeah, that’s a great question. Let’s get to where the rubber actually meets the road and stop speaking theoretically. One big use case here is assessing market moves. So let’s look at an example. Let’s say a stock has a 20% implied volatility, and based on the Rule of 16, we’re thinking about its daily standard deviation as about 1.25%. 

If one day you walk in and that stock, which was trading at $100, is now trading at $107 for some reason — that’s a 7% move. Lots of people are going to look at that and say, “Wow, that’s a big move.” But you don’t really have a very good framework within which to evaluate how big that move actually is. 

What you can do, when you think about it in terms of standard deviations, is look at that and say, “Wow, that’s over five standard deviations of a move” — based on the actual implied volatility where the options were priced beforehand. 

A trader might then be able to ask, “Is this a rational move? Is something unusual happening? Or should I be adjusting my expectations going forward?” That’s something I think is a really interesting part of this — it gives you a framework to evaluate big moves like that when you see them happening. 

Jeff Praissman 

And that “something unusual,” right, could be a micro or macro event — such as a micro event like a very specific earnings release, a news announcement, a drug approval by the FDA — or maybe some bigger-picture, sector-wide or market-wide move, where maybe all the defense stocks are running up, or something like that. 

So I guess traders really have to take into account other information when pairing that with those moves. 

Mat Cashman 

Yes, absolutely. For sure. 

Jeff Praissman 

And I would think another great application is really adjusting expectations for different timeframes. So if I’m selling a 30-day option, I might use the Rule of 16 to gauge how much movement I’m pricing into that period. 

Mat Cashman 

Absolutely. That’s a great way to think about it. It’s a really simple but powerful way to frame your expectations and, in turn, make informed trading decisions. Because implied volatilities are directly linked to option prices — and implied volatilities are directly linked to the standard deviations we’re talking about here. 

So it’s something you can use in a real way to frame your expectations for movement. 

Jeff Praissman 

Yeah, Mat, this has been a great discussion. The webinar was great. This podcast has been great. My takeaway is that the Rule of 16 really helps traders make sense of implied volatility on a practical level. 

But before we wrap up, are there any final takeaways for our listeners that you’d like to leave? 

Mat Cashman 

Yeah, absolutely. I think the core message here — and the key takeaway — is that implied volatility is an annual number, but you trade in days and weeks. 

So the Rule of 16 really helps to bridge that gap between those, so you can think about market expectations in a way that matches however you’re thinking about your trading time horizon. It’s important to be able to match up risk and expectation — and this helps to bridge that gap. 

Jeff Praissman 

Mat, that’s a perfect summary. Once again, thanks for joining us today on the IBKR Podcast. Mat and the OIC are frequent contributors to the IBKR Campus, and his past webinars, articles, and podcasts can be found on our website under Education. Just click on Campus, scroll to the bottom, and choose the Options Industry Council. 

Mat Cashman 

Thanks for having me, Jeff. It was great to be here today. 

Jeff Praissman 

Great. Thank you, Mat. And for our listeners, if you want to learn more about options education, you can check out our website. You can also visit optionseducation.org. Looking forward to seeing everyone next time.