What an insane market it’s been the last few sessions…
Yesterday’s pullback has got traders wondering if stocks will suffer a correction very soon.
Who really knows what will happen right now.
All I know is volatility is picking up at these levels… and it’s something I believe all options traders should focus on.
Today, I want to show you the importance of implied volatility…
And why it’s important to have strategies in your back pocket, to potentially take advantage of pullbacks in volatility.
I know what you’re wondering…
Jason, how would I go about doing that?
A Strategy To Use When Volatility Spikes
Now, if you don’t already know implied volatility (IV) is one of the most important factors when it comes to options trading.
Of course, I won’t go into all the mathematics that go into the calculation for implied volatility…
Before I get into the details of the strategy I want to look to potentially use right now, let me quickly go over the basics of implied volatility.
Of all the components that define an options price, IV is misunderstood the most…
And in my opinion, it’s one of the easiest to use.
Now, all the finance geeks will tell you IV defines the market’s expectations for the move in the underlying over the next 252 trading days (since there are approximately 252 trading days in a year).
Usually, IV is quoted in annualized terms.
If the IV says 100%, that means the market expects a 100% move on an annual basis. To get this number into daily terms, you would simply divide 100% by 15.87 (I won’t get into the details of that).
The thing is… that’s not exactly how it works. IV actually comes from the supply and demand generated by options orders.
That creates moments of opportunity for traders to put IV to work in their favor.
As an options seller, I want to sell when implied volatility is high.
Well, the higher the IV… the more expensive the options.
Implied volatility is actually thought to be mean-reverting.
In other words, if implied volatility spikes way above normal levels… chances are it’ll come back to the average level at some point.
So, if I sell when implied volatility is well above average, then I’ll benefit from any pullbacks in IV.
Many traders use two main methods to understand the current IV.
IV Rank – Implied volatility rank takes the highest and lowest implied volatility values in the past year. Then it tells you where the current IV sits as a percentage of that distance.
Here’s an example. The high and low of implied volatility for a stock was 75% and 15%. Let’s say the current implied volatility is 30%.
The IV rank is calculated as (25% – 15%) / (75% – 15%)… which comes out to about 17%.
With this IV rank, I may not look to sell… but if it gets close to the high point (I may look to sell, say 75% or higher).
Of course, everyone is a bit different when it comes to selling options in relation to where the current volatility is.
Now, with the strategy I utilize, they’re short vertical spreads…
Short Vertical Spreads
Now, there are two ways to use short vertical spreads when implied volatility…
Depending on the outlook I have on a stock, I may use the bear call spread or the bull put spread.
With short vertical spreads, to me, the idea is simple.
If implied volatility is extremely high, I want to use them because these strategies benefit in drops in implied volatility… as well as time decay.
If you really want to learn why I believe these strategies are so powerful… especially when implied volatility is high… then you’ll want to check out my new eBook, Wall Street Bookie.