Better Options Trades Using Implied Volatility

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Better Options Trades Using Implied Volatility

The realities of today’s markets mean that you as a retail trader are seeing big swings and fluctuations in prices. This can leave you feeling like you are stopped out of a trade too soon, or you missed a move, or worse, you bought in the wrong direction. With the bigger moves in the S&P 500, we are also seeing that options prices are more expensive as implied volatility has been increasing. With big price moves, you need to know what strategies will allow you to benefit the most from the market.

When you trade factoring in Implied volatility, you can have a trading advantage. As an options trader, you probably are already aware of the hidden impacts of implied volatility in your options trades. There is a relationship between increasing and decreasing IV and options prices. As implied volatility increases, or when implied volatility is at historical lows for the stock, it is advantageous to buy. As Implied volatility decreases, or IV is at historical highs for the stock, it is advantageous to sell. This is a traditional understanding of IV.

What I want to point out, is that yes as Implied volatility is increasing, it is advantageous to buy, but be careful when buying calls and puts once the Implied volatility has spiked. When the price is already high because implied volatility has inflated the price of put and call options. A stock price will only have large moves for so long before it begins to consolidate or make smaller daily moves. You don’t want to over pay for your calls and puts, expecting to have a larger move just as momentum slows and the stock returns to making daily prices moves that are within its normal range. When you buy high, you risk buying options with a lot of premium embedded in the call or put only to have that premium decrease, meaning you now own a call that is worth less than when you bought it (putting you in a losing position) and the IV becomes a disadvantage to your trades.

When I’m trading in higher IV environments like we have today, I still want to combine Implied volatility with how the price of the stock is moving, specifically focusing on the daily chart.

Implied volatility is different for each stock, while you can compare implied volatility between two stocks to determine which one may experience bigger moves, this does not help with selecting options strategies within the stock you are going to trade options in. In order to use implied volatility effectively, you need to look at how the current IV compares to historical IV of the same stock.

Before you enter a trade ask yourself:

• How does IV compare to historical levels in the short term?
• How does Implied Volatility compare to historical levels in the long term?
• How much time has the stock’s IV spent above or below the current level?

Some examples of what this can mean for your trades:

The amount of time a stock spends above a certain level of volatility is important, it is an indication that a certain stock might like to trade in a certain range of IV.

For example:

A stock might have spent 70% of the last 52 weeks trading with an IV below 25%, which is also at the low end of the stock’s range. Rather than looking for IV to jump back to the high of the range, a trader might conclude that this stock will continue to trade near the low’s of it’s volatility.

When the current implied volatility is:

At the high of the 52 week range. There are upper and lower bounds to a stock’s IV, if the upper bound is historically 30% and IV is now 26% we can say that this stock’s IV is high and would not expect the IV to increase to say 50%.

The same holds true at the lower end of the range, especially for lower IV stocks, the closer to the lower end of the range and 0 you get the harder it is for IV to go lower.

Implied Volatility is a unique statistic, and it can help you understand how the price of an option will react when you are in a trade. Next time you place a trade keep an eye on how IV is effecting the price of the option.

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