Fears of a global economic slowdown and trade tensions between the U.S. and China have left market participants uncertain of whether or not stocks can continue to rise in 2019.
And here’s the thing… whenever uncertainty and fears rise… options become more expensive.
You see, nearly everyone in the market has a long bias– they want stocks to rise.
However, whenever we get spikes in volatility like we have been experiencing over the last week or so, panic starts to set in, and it drives fund managers and traders to pay up for options– helping drive up the price.
The fear of taking a big loss almost forces portfolio managers to buy puts… and the higher the demand for protection… the more expensive options become.
And you know what?
It’s a better time to be a seller of options than a buyer. And I’m going to explain to you exactly why that is, how it works, and how to profit off the strategy right away.
If you don’t know, an options price is calculated using a mathematical formula… and there are a few factors that affect the price. Don’t worry, I won’t be going over any math today… I’m just going to explain to you why implied volatility matters when you’re trading options.
Implied volatility is one of the most important metrics to take into account if you’re going to be trading options… and it’s simply the market’s expectation of how much a stock will move in a year.
So why is this so important?
Well, if you’re looking at options on a stock that is moving a lot, that means those options will be expensive and have a high implied volatility (IV)… and you never want to pay up for your options.
Not only that, when you’re trading options, implied volatility will directly influence your profit and loss (PnL) depending on which side you’re on and which direction the implied volatility moves.
It might be a little confusing at first… but all you need to know is that if you’re long options, you want implied volatility to rise… if you’re short options, you want implied volatility to fall.
For example, let’s say you buy a call option with an implied volatility of 20%. Not only do you need the stock to rise… you also need the implied volatility to rise since you’re long options.
Here’s what I’m talking about…
Here’s a look at a simple options calculator. Let’s assume you’re looking to buy call options on a stock trading at $50 (the underlying price). More specifically, you’re looking to buy the $52.50 strike price options expiring in September, or 42 days from now, with an implied volatility of 20%.
Those call options would be worth around 50 cents.
Not only is this a directional bet… it’s also a volatility bet.
Well, it’s simple… all else being equal, if implied volatility rises, the options price will rise. On the other hand, if implied volatility falls, the options price will fall.
For example, let’s just change the implied volatility to 25%… those calls would be worth 78 cents.
Now, let’s say you’re looking at the same options… but this time when the implied volatility is at 50%… those options would be worth nearly 5 times the price of the same calls with a 20% implied volatility.
Compare this to when the options have an annual implied volatility of 100%…
… the calls with a 100% implied volatility would be worth $5.77… and what happens if the implied volatility gets to 150%?
Well, those options would be worth $9.15.
As you can see, I didn’t change anything else here with the calculator… just the implied volatility… and when you place a directional options bet on a stock, not only do you need the stock to rise, but the volatility as well.
Keep in mind, implied volatility changes all the time.
For example, here’s a look at the chart of Apple (AAPL).
If you look at the very bottom of the chart, you’ll notice the implied volatility in AAPL and how it fluctuates.
Here’s a look at the historical range statistics for AAPL.
Source: Trade Alert
If you look at “30d ATM IV”, you’ll notice that the low was 15.8% and the high was 45.5%. That’s the implied volatility range for AAPL.
So if you want to buy call options in AAPL, you would look to buy when the implied volatility is near the low… not when it’s near the high.
Well, think about it like this… the ranges are like support and resistance for a stock.
At the upper end of the range (45.5%), IV is more susceptible to pullbacks… which would cause you to lose money if you’re long options.
On the other hand, when IV is at the lower end of the range (15.8%), that’s when IV can rebound and cause option prices to rise.
So what happens if you have a directional bias on a stock and want to buy options… but the implied volatility is extremely high and the options are expensive?
Well, there’s actually a better way to play that… and that’s by selling options premiums.
For example, if you sell options premiums when implied volatility is high… you actually benefit from drops in implied volatility… and all you need the stock to do is stay above or below (depending on which options you sell) to make money.
I actually used this strategy to express my bullish opinion on AAPL when it sold off during all the market volatility. During this time, the implied volatility for the options that I sold were actually near the upper-end of the implied volatility range.
So why did I go out and sell put options, instead of buying calls?
Well, the implied volatility was “high” and I didn’t want to put myself at a disadvantage.
Keep in mind, when you sell put options to express your bullish opinion, you should be willing to own the stock at the strike price.
For example, I sold $190 puts in AAPL for $3.78 and $192.50 puts for $2.55. Basically, I was expecting a bounce in AAPL and willing to buy at $190 or $192.50.
However, when you sell options… you can close out when you’re up money… and you’re not locked in to hold it until expiration, so you can always buy to close and reduce your risk of being exercised and having to buy shares at the strike price you sold.
For example, when AAPL started to rise and the implied volatility started to plummet… I was actually closing out my short put options positions… and I was able to lock in 52% on one of those trades in just 1 day!
On the other position, I closed out for a 15% winner overnight.
The whole idea here is to take into account implied volatility when you’re looking to trade options… and if implied volatility is high, you can look to sell options in order to collect option premiums and take advantage of your directional ideas, without having to pay a large premium.
I’ve scored over $7,000,000 in career trading profits, but there is only one options system I follow and trade by. Click here to learn what it is.