Contrary to popular belief…whenever you buy an option you are making more than just a bet on which direction the stock will land.
You are also making a bet on volatility…
That’s why it is so helpful if you zone in on an options implied volatility
When I tell this to LottoX members during our live training sessions, I inevitably get the response…why?
Why should implied volatility matter more than the trade’s direction?
Pay attention because this simple question already starts off the wrong way.
Trade direction is important, but so is implied volatility.
What many of you may not realize is this.
With the well-developed trading strategy, your direction is decided for you!
My TPS Setups illustrate this point beautifully.
Embedded in the selection criteria is a Trend, clear, and obvious to the average observer.
Like this example in Virgin Galactic (SPCE)
Getting implied volatility wrong could destroy a perfect setup!
It all comes down to how option prices work and how implied volatility moves.
I know it might seem like a tall order.
But, I’m confident by the end of this newsletter, you’ll grasp why implied volatility is so critical.
To understand why implied volatility is so important, we need to discuss how option prices work.
Brokers derive option prices from three main components:
- Distance between the strike price and the current stock price
- Increase the distance out-of-the-money, decrease the cost of the option price
- Time left until expiration
- Increase the time left, increase the price of the option
- Implied volatility
- Increase implied volatility, increase the price of the option
Other things like dividends and interest rates do impact the prices, but we’ll ignore them for now since they’re also known items you can look up.
We can control the distance between the strikes and current price as well as time until expiration through the contracts we choose.
Unfortunately, we cannot control implied volatility.
Instead, we choose when we enter the trade.
Let me explain.
Think of implied volatility as the demand for options. It’s a proxy for the uncertainty in the stock, and why implied volatility increases into company’s earnings and decreases immediately thereafter.
Check out how this works in Netlfix (NFLX).
NFLX Daily Chart
You can also think of it as the demand for protection, both to the upside and downside.
Implied volatility mean-reverts. In layman’s terms – it moves towards the average over time.
Stocks may move higher or lower for months or years.
Implied volatility doesn’t.
Over time, implied volatility collapses back towards the average.
In fact, implied volatility declines as an option gets closer to expiration.
This is a concept known as contango.
What’s really cool is how option sellers use this to their advantage. They will sell options 45-60 days out and let the natural decay in implied volatility work to their advantage.
They juice up these trade by picking out stocks with high implied volatility compared to the rest of the year.
A great example – they will sell options for several weeks out right before earnings.
As you can see in the Netflix chart, implied volatility is exceptionally high and then collapses immediately afterward.
Using IV to your advantage
We know that implied volatility heads back to the mean. So, if implied volatility is high, it is likely to fall. If it’s too low, chances are it will rise.
Now, let’s say I want to buy call or put options on a stock. Since I want implied volatility to work for me, stocks with low volatility are better choices.
On the flip side, if I want to sell options, I like to pick out ones with higher implied volatility.
What happens when I’m really bullish on a stock, but it has high implied volatility like due to earnings?
If I plan to hold the trade through earnings, I would sell a put credit spread, getting implied volatility declines working for me.
However, I can also buy a call option that expires after earnings, but sell it before the announcement.
Doing this avoids the collapse in implied volatility that comes after the release and lets the increases in implied volatility leading into the event work for me.
What about when there is no event?
That’s where my experience and analysis of the broader market comes in.
There isn’t always a right or wrong answer here. A lot of it depends on the specifics of the situation.
Generally, if the trade I’m taking is short in duration (a few days) I don’t worry much about implied volatility decreases. Chances are they won’t have enough of an impact on short-dated options.
But, if I’m doing a long swing trade, then I really need to think about how it will affect the trade.
Practice makes perfect
I know that it can be tough to think about all these things at once when taking a trade, especially in real-time.
That’s why I created my LottoX service. You get access to my streaming portfolio, live weekly training, as well as a rundown of the stocks I’m looking at and how I plan to play them.
It’s the educational opportunity of a lifetime you can’t afford to miss.