After a brutal 2022, the S&P 500 (SPY) rallied early in the year – only to give away a significant chunk of its gains. Using a steady hand to control daily volatility is still a very profitable strategy. The year 2023 is shaping up as a market for stock pickers. A simple system of taking profitable bullish positions in good stocks AND taking bearish positions in bad stocks at the same time makes more sense than ever. This kind of balanced approach is likely to continue to perform better in what looks to be a challenging year 2023. Read on to find out more.
Options. Implied volatility. Many traders’ eyes are flooded with trying to understand what is considered too difficult to understand.
In reality, however, the concepts that go into options trading are easier to understand than you might think.
A review of what I consider to be the most important concept, implied volatility (IV), will help you prove this.
The most widely used measure of implied volatility is the CBOE Volatility Index (VIX). Measures the 30-day implied volatility of the S&P 500 index.
Many of you are probably familiar with the VIX having heard about it on major financial news networks. In fact, I talk about VIX every week on CBOE-TV’s “Vol 411.”
People see the S&P 500 as a benchmark for how stock prices generally perform. In a similar vein, option traders look to the VIX as a benchmark for option prices.
A higher VIX means more expensive options. A lower VIX means options prices are cheaper. So implied volatility is just a fancy way of saying “option price.”
Implied volatility can be understood the same way we think about insurance premiums:
- Safe and stable drivers have lower car insurance premiums. Safe, stable stocks with lower volatility have lower option premiums.
- Crazy and reckless drivers have much higher premiums. Wild stocks with higher volatility have much higher option premiums.
So it’s no surprise that option prices are referred to as option premiums and that many portfolio managers buy put options to protect their portfolios from lower prices.
There are six elements that are used to price options:
- Share price
- Strike price
- The term of validity
- Current interest rate
- Dividends (if any)
- Implied Volatility (IV)
The first five are known. You can look at your trading screen and see stock price, strike price, days to expiration.
Interest rates and dividends can be easily found by doing a Google search. The only unknown is implied volatility.
As mentioned earlier, implied volatility is simply the option price. You don’t need to do complicated calculations or calculations shown below to understand IV.
Implied volatility is called implied volatility because it is the input volatility needed to match the option price to the current price. A look at Microsoft Options (MSFT) shows the implied volatility for different strike prices.
Note that different strikes with the same expiration date – in this case April 21 – have different implied volatilities. This is called option skew.
An important takeaway is that out-of-the-money almost always puts trading at a higher level of implied volatility compared to similar out-of-the-money options.
The $230 MSFT put options are priced at 30.60 IV while the $265 calls are priced much lower at 26.27 IV as shown in red.
Both options closed for around $17.50 out of money points. Out-of-the-money refers to the difference between where the stock is traded and the strike price.
Puts are out-of-the-money if the strike price is lower than the current stock price. Calls are out-of-the-money if the strike price is above the current stock price.
In this case, the $230 put options were 17.27 points below Microsoft’s closing price ($246.27–$230) or were that amount out of the money. Calls for $265 were off the counter by $17.73 points.
The main reason for this difference in IV is that stocks are falling faster than they are rising. So down sell options are more valuable than up call options.
Implied volatility tends to be much higher before profits and other corporate events. This makes sense as a potentially big move in stock prices is imminent.
Implied volatility tends to fall after earnings releases or company announcements as the unknown becomes known.
Better understanding that high implied volatility means higher option prices can be critical when considering potential trades. Paying a higher option price means you need more movement in the stock market to justify the trade.
In my POWR Options service, I always perform in-depth analysis of implied volatility, along with the use of POWR ratings and technical analysis as part of the idea generation process.
It is equally important that individual traders always consider implied volatility levels when considering their trades as well.
Implied volatility as a market timing tool
Implied volatility can be used to identify potential turning points in the market. This is especially true when implied volatility reaches extreme values.
The charts below show the VIX at the top and the S&P 500 (SPY) at the bottom. Notice how previous VIX spikes (marked in blue) ultimately signaled significant short-term bottoms in the S&P 500.
Long periods of lows in the VIX are a sign of complacency, which is usually a reliable indicator of short-term market highs, as seen in purple. The latest sell signal was a sign of this.
The old saying of Warren Buffett to “be fearful when others are greedy and greedy when others are fearful” fits perfectly with this VIX market timing methodology.
Trading, as we know, is based on probability, not certainty. Understanding and using implied volatility to put these probabilities in your favor can be a valuable addition to your trading toolkit. At POWR Options, it’s one of the most important tools we use.
What to do next?
If you are looking for the best options trades in today’s market, you should definitely check out this key presentation How to Trade Options with POWR Ratings. Here we show you how to consistently find the best options trades while minimizing your risk.
Using this simple but effective strategy, I achieved a record return of +55.24% since November 2021, while most traders were mired in heavy losses.
If this appeals to you and you want to know more about this powerful new option strategy, click below to access the current investment presentation:
How to trade options with POWR ratings
Here’s a good trade!
POWR Option Newsletter Editor
SPY shares were up $0.24 (+0.06%) in after-hours trading on Friday. Year-to-date, the SPY has gained 5.69%, compared to the percentage increase of the S&P 500 index over the same period.
About the Author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Chief Options Strategist at ThinkorSwim and 3 years as Market Maker for First Options in Chicago. He appears regularly on Bloomberg TV and is a weekly contributor to the TD Ameritrade network “Morning Trade Live”. His overriding passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR Options newsletter. Find out more about Tim’s past with links to his latest articles.
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