After a brutal year in 2022, the S&P 500 (SPY) ripped higher to start the year, only to return much of the gains. Using a steady hand to steer through daily volatility is still a very viable strategy. 2023 will be a stock picker market. A simple system of taking profitable bullish positions in good stocks AND simultaneously taking bearish positions in bad stocks makes more sense than ever. This kind of balanced approach is likely to continue to outperform in what is likely to be a difficult 2023. Continue reading below for more information.
Options. implied volatility. Many traders’ eyes glaze over as they try to understand what is considered something far too difficult to ever understand.
However, in reality, options trading concepts are easier to understand than you think.
A walk through what I consider to be the most important concept, implied volatility (IV), will help you prove it.
The most widely followed measure of implied volatility is the CBOE Volatility Index (VIX). It measures 30-day implied volatility for the S&P 500 index.
Many of you are probably familiar with the VIX from hearing it discussed on the major financial news networks. In fact, I talk weekly about the VIX CBOE TV “Vol 411”.
People think of the S&P 500 as a measure of how stock prices are doing in general. Similarly, option traders look to the VIX as a measure of how option prices are doing.
A higher VIX means more expensive options. A lower VIX means option prices are cheaper. So implied volatility is just a fancy way of saying “the price of the option.”
Implied volatility can be viewed in a similar way to 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. Wilder stocks with higher volatility have much higher option premiums.
So it’s no surprise that option prices are called option premiums and many portfolio managers will buy downside puts as insurance to protect their portfolios against lower prices.
There are six components used to price options:
- Stock price
- Strike price
- Expiration date
- Current interest rate
- Dividends (if applicable)
- Implied Volatility (IV)
The first five are known. You can look at your trade screen and see the stock price, strike price, days to expiration.
Interest rates and dividends are easy to find by doing a Google search. The only unknown is implied volatility.
As said before, implied volatility is simply the price of an option. There is no need to do complicated math or calculations below to understand IV.
Implied volatility is called implied because it is the volatility input required to align the price of the option with the price currently being traded. A look at Microsoft’s options (MSFT) shows the implied volatility for the various strike prices.
Note how different strikes with the same expiration date – April 21 in this case – have different implied volatilities. This is called the skew option.
An important takeaway is that out-of-the-money trades almost always place at a higher level of implied volatility compared to comparable out-of-the-money calls.
The $230 MSFT puts 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 about $17.50 points out-of-the-money. Out-of-the money refers to the difference between where the stock trades and the strike price.
Puts are out-of-the-money if the strike price is less than the current share price. Calls are out-of-the-money if the strike price is higher than the current share price.
In this case, the $230 puts were $17.27 points lower than Microsoft’s closing price ($246.27-$230) — or out-of-the-money by that amount. The $265 calls were $17.73 points out-of-the-money.
The main reason for this difference in IV is the fact that stocks fall faster than they rise. So downward puts are more valuable than upward calls.
Implied volatility tends to be much higher in light of earnings and other business events. This makes sense since a potentially large move in the stock price is looming.
Implied volatility usually drops after earnings release or company announcement as the unknown becomes known.
Having a better understanding that high implied volatility means higher option prices can be vital when considering potential trades. Paying a higher option price means you need a bigger move in the stock to justify the trade.
In my POWR options service I always do in-depth implied volatility analysis along with using the POWR ratings and technical analysis as part of the idea generation process.
It is equally important for individual traders to always consider levels of implied volatility when considering their trades.
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 becomes extremely high.
The charts below show the VIX at the top and the S&P 500 (SPY) on the bottom. Note how the previous peaks in VIX (highlighted in blue) eventually signaled significant short-term bottoms in the S&P 500.
Long periods of low levels in the VIX are a sign of complacency, which is usually a reliable indicator of short-term market highs, as seen in purple. The most recent sell signal was a sign of that.
The old Warren Buffett adage, “be fearful when others are greedy and be greedy when others are fearful,” applies perfectly to this VIX market timing methodology.
Trading, as we know, is all about probability, not certainty. Understanding and using implied volatility to turn those odds in your favor can be a valuable addition to your trading toolbox. In powr options it is one of the most important tools we use.
What to do now?
If you’re looking for the best options trading for the current market, be sure to check out this important presentation How to trade options with the POWR ratings. Here we show you how to consistently find the best option trades while minimizing risk.
With this simple yet powerful strategy, I have achieved market-beating returns of +55.24% since November 2021, while most investors have suffered heavy losses.
If that appeals to you and you want to learn more about this powerful new options strategy, click below to access this current investment presentation now:
Editor, POWR Options Newsletter
SPY shares rose $0.24 (+0.06%) in after-hours trading on Friday. Year-to-date, SPY has gained 5.69% versus a percentage increase of the benchmark S&P 500 index over the same period.
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Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim, and 3 years as Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His main passion is to make the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.