By Michael C. Thomsett
Implied volatility is an estimate based on current levels of price and moneyness, but these matters change every day.
Timing of option trades is likely to be improved by relying more on price-related and momentum signals, and not aimed at the effort to estimate future volatility. Today’s volatility tells traders what they need to know to time their decisions profitably. Consideration such as moneyness and proximity matter. When the current price per share is close to the option strike, timing is likely to be improved, whether entering or exiting. Another form of proximity is related to price in comparison to resistance or support. Most reversal signals are most reliable when they occur right at these trading range borders. If price gaps through resistance or support, and reversal signals appear, this is exceptionally strong timing for options trades.
Options traders often prefer implied volatility (IV) to time trades, but this rarely makes sense. IV has value to some extent, but it is an estimate only and is based on what you see today, not on what is likely to happen in coming days or weeks. Traditionally, traders like to enter long trades when IV is low and exit when it increases; or to enter short trades when IV is high and exit when it declines. However, analysis reveals that this is equally effective when applying the analysis to historical volatility, which is more reliable because it is factual and not an estimate.
Support for relying on IV comes largely from academia, where IV is tied directly to the efficient market. However, this also is flawed. The efficient market hypothesis (EMH) states correctly that prices efficiently take news into the price immediately. However, no distinction is made between true news and rumor, so false information has the same effect on price as true information. This efficiency also fails to identify how far a stock price should move. Anyone who has observed market reaction to earnings surprises sees a big price move, often exaggerated. In comes sessions, the price retraces to previous level.
This is not efficient.
That’s the entire point. EMH is poorly named because it implies that markets are efficient, when in fact only discounting of all information (true and false) is efficient. When options traders rely on IV and point to “efficiency” as justification, they are relying on a signal containing no true value.
Proponents of IV claim that (s) the market is efficient, and this is reflected in IV and (b) this fact allows traders to accurately predict the future.
However, the efficiency of price behavior based on information often gives off a false signal, so that IV itself reflects the inefficient interpretation of price. Traders know that short-term price behavior is inefficient and chaotic, so that IV – as a direct factor of this assumption – is not reliable for timing trades.
A related problem is the significant variance in IV based on moneyness of different strikes and time to expiration. Informed short traders know that time is an ally, and time decay is a primary source for profits. However, this is easily based on historical volatility rather than on the less reliable implied volatility. A debate about which form affects option premium is unsettled; but traders will discover that relying on historical volatility provides reliable timing information to exploit volatility.
The problems with IV are evident in the wide variances of levels based on moneyness and time to expiration. This tendency to vary is called the volatility surface, and it relies on current option premium levels as the source for future movement; in truth, those premium levels are not the source, but the result of historical volatility and moneyness. A detailed study of stock and option prices concluded that there is no consistent evidence that IV determines or affects future option value. 
IV is not accurate or reliable, despite common belief that it is both. Another study pointed out that IV is not a valuable indicator at all:
In theory, the implied volatility is the market’s well-informed prediction of future volatility. In practice, however, the arbitrage trading that is supposed to force option prices into conformance with the market’s volatility expectations may be very hard to execute. It will also be less profitable and entail more risk than simple market making that maximizes order flow and earns profits from the bid-ask spread. 
Although there are five factors going into the Black Scholes pricing model (BSM), only volatility is unknown and must be estimated; and this is where inaccuracy comes into play, making the pricing model deeply flawed.
The intent of IV is to identify current volatility and predict future volatility, but it cannot predict the future. Volatility itself (defined as “risk”) cannot be quantified for the future in any case, so any assumption by traders that IV is a reliable test of future price movement, is simply untrue. This is easily demonstrated by another factor: Volatility reveals the likely movement of an option’s premium, but not the direction. Options traders are naturally interested in figuring out where the price will move, but volatility articulates the range of price movement and not the direction.
A final flaw is that as expiration approaches, volatility will become as uncertain as price of the underlying. This “volatility collapse” makes IV unreliable in the final week before expiration. But this is the week where many traders focus. If a trader is active in the final week of the option’s term, but also relies on IV, there is no certainty whatsoever of profitable outcome. A simple observation of moneyness and proximity to resistance or support makes more sense.
The use of IV can be compared to reliance on forward P/E. This is an estimate of future P/E but contains assumptions, often based on wishful thinking or flawed assumptions. It may also be compared to the accounting reliance on pro forma financial statements, estimates of future revenue, costs and net profit. This may be based on detailed forecasting that sounds scientific but, in fact, cannot be called accurate. If traders know that estimates of future P/E or net profits are unreliable, why depend on IV to estimate future volatility of options?
 Bouchard, Jean-Philippe & Marc Potters (2009). Theory of Financial Risk and Derivative Pricing: From Statistical Physics to Risk Management (2nd ed.). Cambridge UK: Cambridge University Press. p. 252
 Figlewski, Stephen. (2004). Forecasting Volatility, New York University Stern School of Business, Preface
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
By Nathan Wade
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.
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.
Where is the best place to find a list of low IV stocks such as NKE that will have really strong Gamma gains on moves. I've had success trading straddles on NKE before joining the group and is it a matter of looking through a bunch of stuff or is there a site that will help aid in that search?
Consider selling strategies when options are being traded at high implied volatility levels.
Consider buying strategies when options are being traded at low implied volatility levels.
The following infographic explains some of the aspects of the Implied Volatility:
1. What is Implied Volatility?
2. 2 types of volatility.
3. How options are affected by Implied Volatility?
We invite you to join us and learn how we trade our options strategies.
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However, not all stocks are suitable for that strategy. Some stocks experience consistent pattern of losses when buying premium before earnings. For those stocks we are using some alternative strategies like calendars.
In one of my previous articles I described a study done by tastytrade, claiming that buying premium before earnings does not work. Let's leave aside the fact that the study was severely flawed and skewed by buying "future ATM straddle" which simply doesn't make sense (see the article for full details). Today I want to talk about the stocks they used in the study: TSLA, LNKD, NFLX, AAPL, GOOG.
Those stocks are among the worst candidates for a straddle option strategy. In fact, they are so bad that they became our best candidates for a calendar spread strategy (which is basically the opposite of a straddle strategy). Here are our results from trading those stocks in the recent cycles:
TSLA: +28%, +31%, +37%, +26%, +26%, +23% LNKD: +30%, +5%, +40%, +33% NFLX: +10%, +20%, +30%, +16%, +30%, +32%, +18% GOOG: +33%, +33%, +50%, -7%, +26%
You read this right: 21 winners, only one small loser.
This cycle was no exception: all four trades were winners, with average gain of 25.2%.
I'm not sure if tastytrade used those stocks on purpose to reach the conclusion they wanted to reach, but the fact remains. To do a reliable study, it is not enough to take a random list of stocks and reach a conclusion that a strategy doesn't work.
At SteadyOptions we spend hundreds of hours of backtesting to find the best parameters for our trades:
Which strategy is suitable for which stocks? When is the optimal time to enter? How to manage the position? When to take profits?
The results speak for themselves. We booked 147% ROI in 2014 and 32% ROI so far in 2015. All results are based on real trades, not some kind of hypothetical or backtested random study.
How We Trade Straddle Option Strategy
How We Trade Calendar Spreads
Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
The Less Risky Way To Trade TSLA
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The problem is you are not the only one knowing that earnings are coming. Everyone knows that some stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper.
Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses.
However, there are always exceptions. Stocks like NFLX, AMZN, GOOG tend on average to move more than the options imply before earnings. It doesn't happen every cycle. Few cycles ago NFLX options implied 13% move while the stock moved "only" 8%. A straddle held through earnings would lose 32%. A strangle would lose even more. But on average, NFLX options move more than expected most of the time, unlike most other stocks.
NFLX reported earnings on Monday October 17. The options prices as indicated by a weekly straddle "predicted" ~$10 (or 10%) move. The $100 calls were trading at $5 and the puts are trading at $5. This tells us that the market makers are expecting a 10% range in the stock post earnings. In reality, the stock moved $19. Whoever bought the straddle could book a solid 90% gain.
Implied Volatility collapsed from 130% to 36%. Many options "gurus" advocate selling options on high flying stocks like NFLX or AMZN, based "high IV percentile" and predicted volatility collapse. However, looking at history of NFLX post-earnings moves, this doesn't seem like a smart move.
As you can see from the table (courtesy of optionslam.com), NFLX moved more than expected in 7 out of 10 last cycles. For this particular stock, options sellers definitely don't have an edge, despite volatility collapse. If the stock moves more than "expected", volatility collapse is not enough to make options sellers profitable.
Generally speaking, I'm not against selling options before earnings - on the contrary. For many stocks, options consistently overestimate the expected move, and for those stocks, this strategy might have an edge (assuming proper position sizing). But NFLX is one of the worst stocks to use for this strategy, considering its earnings history.
Why We Sell Our Straddles Before Earnings Why We Sell Our Calendars Before Earnings How NOT To Trade NFLX Earnings The Less Risky Way To Trade TSLA
If you want to learn how to trade earnings the right way (we just booked 26% gain in NFLX pre-earnings trade):
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This cycle was no exception.
It is a well known fact that Implied Volatility of options increases before earnings. We usually take advantage of this phenomenon by buying a straddle option few days before the earnings date.
However, Oracle case was slightly different. As I mentioned, they follow a similar pattern of earnings dates in the last few years (third week of the month), but for some reason, the options market tends to be "surprised" after the earnings date is actually confirmed.
On February 27 I opened ORCL trade discussion topic and posted the following information:
My initial intention was to trade the Mar.24 straddle, which would be a safer bet.
However, after checking again the previous cycles and seeing the Mar.17 straddle dipping below $1.45, I decided to take the risk and execute the Mar.17 straddle. The trade has been posted on the forum on Mar.01:
I posted the rationale for selecting the Mar.17 expiration, with all supporting information, including the risks:
Two days later, Oracle confirmed earnings on Mar.15, as expected.
IV of Mar.17 options jumped 4 points after the date has been confirmed, and we closed the trade for 20.1% gain.
This is a great example how we make Implied Volatility to work for us. We implement few strategies that take advantage of Implied Volatility changes around the earnings event.
Of course, this trade was not without risks. If earnings were confirmed on week of Mar.24, the Mar.17 straddle could easily lose ~40%. But options trading is a game of probabilities. Based on previous cycles, I estimated that there was ~90% chance that earnings will be on week of Mar.17. Making 20% 9 out of 10 times and losing 40% in one trade still puts you far ahead, with 140% cumulative gain. I also provided members all the necessary information so everyone could make an educated decision.
At SteadyOptions, the learning never stops. If you think education is expensive, try ignorance.
How We Trade Straddle Option Strategy
Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings
Options Trading Greeks: Vega For Volatility
Want to learn more? We discuss all our trades on our forum.
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By Mark Wolfinger
I received this very upsetting note yesterday.
I read in your book about volatility as one of the important factors of the price of an option
I have a few question about, what you wrote.
Implied Volatility vs. Future Volatility
1) In your book you say that volatility is unknown and different traders can get different values… but I have account with 3 brokers and they show the same (or very similar price) for the volatility…
Future volatility is unknown. However, the market makers must make some volatility estimate or else they would be unable to establish bid and ask quotes.
Your brokers are showing the IMPLIED VOLATILITY (IV) OF THE OPTIONS. They do not make estimates for the future volatility. They use the implied volatility because that is the best current estimate for future volatility. And that estimate changes, depending on many factors, including order flow (supply and demand).
IV is often the best value we can use – unless you want to make your own estimate – and I doubt you want to try that.
By definition IV is the volatility estimate that makes the fair value of any option equal to whatever price it is trading at in the marketplace. I was writing about people who make their own volatility estimates. They are the ones who cannot agree on what the volatility estimate should be and they are the traders who have different opinions on the value of an option. Those are the traders who could believe an option to be over- or under-valued in the marketplace. Not the brokers. They do not have an opinion.
You will probably never make an estimate, but others can and do. You and I usually trade based on the assumption that the current IV and the current option prices represent fair value. But we can decide to go longer short vega, based on the current ‘fair value’ if we believe it is too high or too low. You can trade volatility if you so desire.
Selling Leveraged ETFs Options
2) Since a lot of volatility, means that I can sell “expensive” options, doesn’t it make sense to sell options on Leveraged ETFs, such as FAS or FAZ, that have a lot of volatility?
NO. If the underlying asset is VOLATILE then the underlying asset will undergo big price changes. If you sell options on stocks that make BIG MOVES, there is a good chance that the options will move ITM and that you will lose money. To compensate for the risk of selling options on volatile stocks (or ETFs), the options are priced higher. In other words, you get a higher premium, but that premium is justified.
Your question frightens me.
The pricing of options is a very basic concept. It may not be easy for us to know whether an option’s price is fair, but we have to accept the fact that the option premium that we see is the premium we can trade. If we choose to sell that premium, we do so believing that we have an edge.
Volatile stocks have options with a high premium. Non-volatile stocks have options that carry much smaller premium. Surely you know that is true.
When the stocks are volatile, option buyers are willing to pay higher prices because there is a decent chance the stock will undergo a significant price change that favors the option buyer (assuming he correctly bought puts or calls).
Low-volatile stocks trade with much smaller premium because they are not likely to move far. People do not pay much for options when there is a high probability that the stock price will not vary too much during the lifetime of the option..
You must understand this. There is no way you can survive if this concept is not understood. Selling high-priced options because they are high-priced is foolish. The options carry a higher premium for a reason.
What we want to do – and it is quite difficult – is to sell options when the implied volatility is higher than the future volatility of the stock will be. In other words, option buyers are paying for future volatility of the underlying. If that underlying asset is less volatile than expected, then we collected more premium than our risk deserved. Thus, we stand to profit over the longer term. But we do not know the future and we do not KNOW which options are priced too high. The bottom line is:
It is wrong to believe that you can earn more money by selling options on volatile stocks or a leveraged ETF.
You cannot trade options if you do not understand this principle.
and last question
Should I Use Portfolio Margin?
3) Do you think that a “portfolio margin” account, with more leverage, is a good idea? I would use all the leverage to sell options with 95% or more chance to expire worthless (and with the 5% I either get assigned, or roll out). Is this plan too risky?
Portfolio margin allows traders to take a lot more risk. Reg T margin is far more limiting. I prefer Reg T margin because it removes the temptation for a trader to get in over his head. Yes, a lot more risk.
If you are positive that you can handle the risk; if you are certain that you will NEVER, EVER allow yourself to have too much exposure to a big loss; if you are already a consistently profitable trader; if you are disciplined and will not use all available margin (above, you suggest that you would use all available leverage), or anywhere near all of it; then maybe you can use portfolio margin. But not now. Not if you do not understand the most elementary concept mentioned above.
Let’s examine your question. You want to sell 5-delta options and expect to win 95% of the time. You plan to roll out or accept assignment on the 5% of the trades that end up with your short option being in the money. If that is true, then the plan is to hold all shorts until they expire worthless. All by itself that adds to risk. Some of those short options will be worth covering before they expire – just to minimize risk.
You also must understand that you will not win 95% of the time unless your plan is to hold through expiration and not apply any risk management. But if you plan to roll out some trades that are not working, that already tells you that the 95% success expectation is just too high.
Many times you will get too frightened to hold the trade and be forced to cover because even rolling out will leave you with a dangerous position.
Consider this: You will not like the size of any loss. When you sell an option at a low price, it becomes very difficult for the undisciplined trader to pay 10 times as much to cover the short. Rolling out will not help. If your plan is to roll to a new 5-delta option, that will be a costly roll. If you plan to roll out for even money, then the short option will have a delta much higher than 5, and you will be taking more risk than your plan calls for. Please consider all aspects of your plan before taking action.
So will you do it? Will you have the discipline to cover your shorts and lock in a good-sized loss? If the answer is not ‘ABSOLUTELY, YES’ then you cannot afford to use portfolio margin. Nor can you expect to make money by selling 5-delta options. That strategy is viable only for the disciplined (and experienced) trader. In my opinion, selling those low-delta options is not a good plan.
There will be a day when those 5-delta options KILL you. It will not occur too often, and it will not necessarily come soon, but that day will arrive. There will be a big gap opening with a huge IV increase. There will be a day when those options you sold for 40 cents or one dollar will be trading at $20. At that point, the option’s delta easily could be between 35 and 60. Your account will be in deficit and you will be forced to buy back all of those options and your account will be worthless and you will owe your broker hundreds of thousands of dollars.
If that sounds bad, the reality is even worse. The bid ask spreads would get very wide and your broker will buy those options by entering market orders. They will not ask your permission. You would be blocked from trading and your positions would be closed. Thus, you would not only pay that exorbitant implied volatility, but you would pay the ask price on a wide market. See for yourself. Lower the underlying price by 20%, double IV and see how much those options are worth And doubling IV may not be enough. IV is so are low right now that tripling of IV is a reasonable possibility.
DO NOT DO THIS. No portfolio margin, and more importantly, if you do sell 5-delta options, you MUST watch position size. That is most important. I know that you do not want to believe that these warnings apply to you. But they do.
I wish you well. But you scare me.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
If I know IV at open can calculate the price and vice versa. At the Open know neither. IV at the subsequent, published Close cannot be used since IV is not constant during the day. How is the price or IV calculated at the Open?
I need this for back testing. Do not have funds to pay for data.
Implied volatility increases when the market is bearish. On the other hand, it decreases when the market is bullish.
Implied volatility can be derived from the cost of the option. If there are no options traded on a given stock, there would be no way to calculate implied volatility. If there is an increase in implied volatility after a trade has been placed, the price of options generally increases. This is good for the option owner whereas bad for the option seller. If implied volatility decreases after the trade is placed, the price of options also decreases. This is good for the option seller and bad for the option owner.
In order to know more about implied volatility, please refer the given infographic.
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