SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Selling Options When Implied Volatility is High


In the second week of October 2018, the Dow Industrial Average tumbled 1,300 points within a two-day period just ahead of earnings season. How did it happen? There were several explanations for why stock prices sold off, but the most obvious was that investor fear had changed market sentiment.

As public fear escalates, demand for protection against downward shifts in the stock market increases with it. This boosts the premiums for options that can be used to hedge against downward shifts in stock prices.


While some investors invest in either stocks or options, many investors use options to hedge their stock portfolios. They look for overvalued options, so that they may sell options when the premiums of those options are expensive. The best way to determine if an option premium is overvalued is to analyze implied volatility.


What is Implied Volatility?

Let’s say you have a call option. When you hold a call option, you have the right (but not the obligation) to buy a security at a specific strike price on or before its expiration date. The value of this option is determined by the probability that the call option will be in the money by the time it reaches its expiration date.


To determine the likelihood that an option will be in the money before the expiration date, you need to figure out how quickly it will move in the right direction. But how do you do that?


Option traders, like Warren Buffett, turn to implied volatility. Implied volatility is a measure of how much market participants believe the price of a security will move over a specific period on an annualized basis. It’s typically represented as a percentage.


An implied volatility of 20% means that traders estimate a security will move up or down 20% from its current position over the next 12 months. To determine the premium, or price, of an option, you could use an option pricing model. The most famous is the Black Scholes option pricing model. There are several inputs, but the most crucial is implied volatility.


How Do You Measure Implied Volatility?

There are a few ways to measure implied volatility—but the easiest way is to evaluate an available index of implied volatility.


You can chart implied volatility on several instruments including the VIX volatility index.  Additionally, you can use technical analysis tools such as Bollinger bands and the RSI to help you decide of the value of implied volatility is rich or cheap.


The VIX volatility index, which is calculated by the Chicago Board of Options Exchange (CBOE), lists the implied volatility of the “at the money” calls and puts on the S&P 500 index. The VIX reports how far traders believe the S&P 500 will move over the course of the next year.


The CBOE produces many different VIX indexes. There is a VIX on Apple shares and a VIX on crude oil. By charting the VIX, you’ll be able to determine whether implied volatility is rich or cheap.


image.png
 

How Do You Know When Implied Volatility is Rich?

When implied volatility is high, or “rich,” option prices are overvalued. This attract investors like Buffett. This is when you want to sell options.


You can determine how rich volatility is by using technical analysis tools like Bollinger bands or the Relative Strength index. When the value of the VIX moves up to unsustainable levels, you’ve reached a trigger point. This is where you should look to sell options.


Bollinger bands are a technical analysis tool that measure a 2-standard deviation range around a moving average.


The chart of the VIX shows that the VIX shot above the Bollinger band high in early October, which was calculated using a 200-day moving average. This also happened in March and February of 2018. When the VIX crosses above the Bollinger band’s high, it’s likely to revert back to the mean. But before it returns, you can attempt to sell an option. You can use several different moving averages to determine if the value of the VIX volatility index is high. It all depends on your time horizon.


A second technical analysis gauge you can use to determine if implied volatility is rich is the relative strength index (RSI). This is a momentum oscillator that measures accelerating and decelerating momentum along with overbought and oversold levels. When the RSI moves above 70, the value of the security is overbought and will likely correct itself. In early October the VIX hit an RSI reading of 84, well above the overbought trigger level of 70—meaning the volatility was rich.


There are other tools that you can use to measure implied volatility. There are vendors that provide historical charts of implied volatility on  individual stocks. You can use the same type of technical analysis tools to determine whether the implied volatility on these shares are rich or cheap.
 

When Should I Check Implied Volatility?

You can use implied volatility as a confirmation indicator or a trigger. The process goes as follows:


Once you find a stock that you believe is undervalued, you might consider selling a naked put below the current stock price.


You would then check the stock to see if current implied volatility is elevated and use that to determine whether or not selling an option on that stock is worthwhile. Alternatively, you can use implied volatility as a trigger. In this case, you could scan for implied volatility levels on stock prices where the Bollinger band’s high has been breached or the RSI is above the 70 overbought trigger level.


You can then find a level that would make selling a naked put or a covered call attractive.


A Final Message

The best options strategies are income producing option trading strategies. These include popular trading strategies, such as covered call and naked put trading. It does not matter if you are selling a naked put or employing a covered call strategy, you want to sell options when premiums are overvalued.  

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 195 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 213 views
  • Do Options Affect Stock Prices?

    It is widely acknowledged that the price of the underlying directly impacts the premium of the option. Therefore, options are termed derivatives. Their current value is directly derived from movement of the underlying price. Is the opposite also true? Does movement of the option value affect the underlying price?

    By Michael C. Thomsett,

    • 0 comments
    • 408 views
  • Portfolio Withdrawal Strategies

    This article will discuss three ways to take systematic withdrawals from your investment portfolio that would be expected to last 30 years, which is a typical time period a 65-year couple might need to plan for in retirement.

    By Jesse,

    • 0 comments
    • 304 views
  • Pricing Models and Volatility Problems

    Most traders are aware of the volatility-related problem with the best-known option pricing model, Black-Scholes. The assumption under this model is that volatility remains constant over the entire remaining life of the option.

    By Michael C. Thomsett,

    • 0 comments
    • 485 views
  • Option Arbitrage Risks

    Options traders dealing in arbitrage might not appreciate the forms of risk they face. The typical arbitrage position is found in synthetic long or short stock. In these positions, the combined options act exactly like the underlying. This creates the arbitrage.  

    By Michael C. Thomsett,

    • 0 comments
    • 684 views
  • Why Haven't You Started Investing Yet?

    You are probably aware that investment opportunities are great for building wealth. Whether you opt for stocks and shares, precious metals, forex trading, or something else besides, you could afford yourself financial freedom. But if you haven't dipped your toes into the world of investing yet, we have to ask ourselves why.

    By Kim,

    • 0 comments
    • 496 views
  • Historical Drawdowns for Global Equity Portfolios

    Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.

    By Jesse,

    • 0 comments
    • 481 views
  • Types of Volatility

    Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.

    By Michael C. Thomsett,

    • 0 comments
    • 605 views
  • The Performance Gap Between Large Growth and Small Value Stocks

    Academic research suggests there are differences in expected returns among stocks over the long-term.  Small companies with low fundamental valuations (Small Cap Value) have higher expected returns than big companies with high valuations (Large Cap Growth).

    By Jesse,

    • 0 comments
    • 1,052 views

  Report Article

We want to hear from you!




Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido