Market drops scare the lights out of most retail traders. They see headlines like ‘Dow down 1,000’ and panic and fear overcome them.
That’s the exact wrong time to be exiting the market. Strong drops in the market increase implied volatility which works great for option sellers.
Look, I’m glad I dumped all my positions on Friday. It cost me a lot of money. But if I held them through Monday it would have been a whole lot worse.
With a clean slate, I’m looking for my spots to enter into trades. As stocks decline, their option prices increase. Rather than buying options, I want to sell them and collect the premium.
Today I’m going to explain to you how such a strategy works, and where I’ll be looking to make these plays.
A lot of people get confused about implied volatility. They read three or four definitions, browse through a couple of formulas, and throw up their hands in frustration. Let me explain how I look at it.
Implied volatility is the market’s way of saying – this is the percent I expect the stock to move by expiration if you annualized the number. For example; if a stock had an implied volatility of 15% for an expiration 30 days out, that means the market expects it to move say 3% in the next thirty days. But if you annualized it, that would be 15%.
Now here’s what’s interesting about implied volatility. In the majority of cases it overstates realized volatility.
Think about that for a second. Implied volatility is a component to price an option and it is usually overstated. That means that option prices are often overstated.
That’s why option sellers statistically have an advantage over buyers.
Ready for the best part?
You can increase your odds by picking which implied volatility levels you sell at!
Implied Volatility and Market Drops
Stocks and volatility have an inverse relationship. When stocks drop, implied volatility rises. Implied volatility falls when stocks rise. This doesn’t happen 100% of the time, but the vast majority.
You’ve probably heard someone talk about mean-reversion before. That simply means that whatever you’re looking at has a tendency to move back towards the average. The VIX is mean-reverting. It rarely gets above $40 and below $10.
Implied volatility for stocks works the exact same way. Their price can swing all over the place. But their implied volatility tends to revert to the mean.
Putting the two together
Now that you’ve got the foundation for the trade, let me explain how to put it together. Traders measure implied volatility through two measures: IV Rank and IV Percentile.
IV rank looks at the entire range for implied volatility in the last year and tells you where the current IV stands in percentage terms. For example, if the IV range for a stock was 35-50 in the last year, and the current IV is 40, the IV rank is 33.3.
IV percentile looks at the implied volatility for every trading day in the last year and tells you where the current implied volatility lands among that data set.
In most cases, I want to use IV Rank. The higher the IV rank, the better.
Option prices are made up of three main components – the distance between the strikes and the current price, time to expiration, and implied volatility.
So, if I sell options when implied volatility is high, and I know implied volatility is mean-reverting, then I give myself an edge. All things being equal, implied volatility will contract, which means that I get time decay and implied volatility contraction working in my favor. That increases my profits on my trades!
Check out different IVs change the premium when you keep expirations and distance to price constant.
Setting up for success
It will feel really wrong when stocks are falling and you’re betting they aren’t going any lower. There are a few keys to making this work.
- Give yourself enough time. There’s no reason to try to play options expiring next week or the week after. Instead, go out 30-60 days.
- Use IV Rank to guide your choices. Look for ones with IV Rank above 50.
- Go out-out-of-the money when you sell your spreads. Because premiums are so high, you can go out to 30 to 15 delta and get great probabilities
- Use defined risk trades like credit spreads and iron condors. Iron condors work best if you simply want to be neutral.
- Scale into your trades. Down moves in the markets can last a lot longer than you might expect. Make sure you save some firepower if things get worse.