Implications of Implied Volatility

Dream Big!
Never let anyone tell you you’re not scary!

– Mike Wazowski (Movie: Monsters University)

Prologue

When I first started Options trading last year, I went through a slew of webinars and online courses from Ameritrade. The Options Greeks were a dominant topic amongst those lessons and extremely esoteric without any real-world references. Now, after a year of low-risk Options trades practice, I can confidently say, “I still don’t have a clue, but I do have an appreciation!” But like the Monsters in the Monster Inc. movies – they are all icky – but at the same time adorable.

The mysterious VooDoo equation behind setting the price of an Option is impressive (Black-Scholes Model). There are lots of oozing parts and funny characters required. As a result, the premium price will be set using, among other components, the current Implied Volatility according to its Standard Deviations. When drawn as a chart, the Standard Deviation bell chart even looks like Roz…

This post is my high-level understanding of Implied Volatility and how I should view this as one of my matrixes. There is nothing here on how to calculate IV since the Internet has plenty of info.

When I consider that Options trading is not the buying or selling of stocks but the buying and selling of what the other traders think about how stocks will perform in a defined future, then I can think of Option contracts as insurance contracts.

When there is uncertainty about the stock’s future, then there is a higher demand for insurance, and that higher demand will drive the insurance premium prices up. Likewise, where there is little concern about the stock’s future performance, then there is not much demand for stock insurance. Thus the premium price for the option falls.

Implied Volatility (IV) is simply the volatility as implied (future tense) by the market. It is not steered by Historical Volatility but by the currently unsatisfied supply and demand of stock insurances. It’s like reverse-engineering the underlining price’s future volatility based on the market traders’ current perception.

Being blind to all other things, when I look at IV, this is what I see:

• If IV is rising or high, then the trading population feels an increasing amount of angst with the stock’s future performance. IV can increase when it gets close to the quarterly earnings report or good/bad news about the stock’s company or from a tweet from Trump. That angst translates into higher demand for insurance, which will increase the Options premium price.
  
• If IV is falling or low, then there is not too much concern about the stock’s future (boring). Not too many traders are interested in buying the insurance, and therefore, the price of the Options premiums are low.

What can I do with IV:

• When IV is rising or at high levels, I can consider strategies like Credit Spreads. Because IV is high, the premiums I received from selling options will also be high while the dollars at risk are pushed lower (due to the increased premium). This strategy generates a higher ROC.
  
• If IV is high and I am concerned about the near-future direction of the underlining stock, I can decide to sell a deeper OTM Vertical Credit Spread that will still yield an acceptable ROC.
  
• When IV is low or falling, I can consider Debit Spread’s strategies. With a low IV, the premiums I have to pay to buy these options would be less while the projected profit increases (again due to the decreased premium). A Debit Spread at a low IV will also generate a higher ROC than a Credit Spread at the same IV.
  
• I can also use IV to help select strike prices by using the equation below. These suggested strike price can be a starting point for the short leg(s) of either a Vertical Bull Put Credit Spread or an Iron Condor:

For example, consider an Oct 4, 2019 Option for ETF:DIA:

• Days to expiry = 26
• Current DIA price = $268.32
• Current IV at $268.32 = 15.99%
• 268.32 * .1599 * sqrt(26 / 365) = $11.45
• Estimated short strike price for Vertical Put Spread ($268.32 – $11.45) = $256.87
• Estimated short strike price for an Iron Condor ($268.32 + $11.45) = $279.11

Consider the Standard Deviation chart below. Using the above formula I can assume an (34.1% + 34.1% + 13.6% + 2.1% + .1%) 84% chance that the price of DIA will fall above the short put strike of $257.

P&L and Performance Status

YTD (2019)

Realized Net Profit from Spreads: $-1,072.50
Spreads started: 58
Realized ROC (target = 72% for the year): -27%

A little caveat to the dismal P&L shown above. Earlier this year, I made a lot of rookie mistakes, and I’m still paying the price. It’s going to take a couple of months to recoup, and I do feel I have improved my trading understanding to fair better.

Last Month (Aug)

Realized Profit: $130.45
Spreads Started: 10 (3 still spreads open)
Realized ROC (target = 6.0%): 6.5%

Spread Trades Won: 5
Spread Trades Lost: 2
Win Ratio: 71%

MTD (Sept)

Realized Profit: $0.00 (No trades closed yet)
Spreads Started: 4 (4 still open)
Current at risk $$$ for Spreads (Max: $3,960): 1,375.85 (34.7% of max risk)
Realized ROC (target = 6.0%): 0%

Spread Trades Won: 0
Spread Trades Lost: 0
Win/Loss Ratio: 0%

Schedule for this Week

Monday:

• Review and tweak the Trend-Channels for the general market direction. Determine if the IV is high or low so I can better choose Debit or Credit spreads.
• Review and tweak Trend-Channels for all stocks in the watch list.
• Confirm that the target expiration date for all options trades is set to Oct 4 (25 days).
• By 10 AM, stage possible trades for all watch list stocks (but don’t trade anything).
• Watch 1 Webcast or take one online mini-course to be completed by Friday.  

Tuesday:

• Review how yesterday’s staged trades moved. Adjust premiums to take advantage of movement (these are “long-shots”). 
• Submit a couple of Spreads, but keep a close watch. If one takes, cancel the others (we just want one new active trade). 

Wednesday:

• If no “long-shot” spreads were accepted yesterday, then readjust premiums closer to ATM prices and resubmit. We want only 1 spread accepted so keep watch.
• Recheck/tweak trend-channels. 

Thursday:

• Reset target expiration date to Oct 11 (29 days out to the following Friday). 
• By 10 AM, stage possible trades for all watch list stocks. 
• Submit a couple of Spreads, but keep a close watch. If one takes, cancel all others. (Do not submit a trade with for the same ETF as Tuesday.)

Friday:

• Same as Wednesday.
• Update trading journal (this blog) and update it to the Internet by end of the day.
• Make sure you watched a webcast.

Trades Ended prior to 9/6/19

QQQ: $183.5c/185.5c – 1 Contract – Open 8/6 – Expires 8/30 – Net Debit = -$115.95
(Vertical Bull Call Debit Spread)
Open: Prob. ITM = 40.1%, ROC = 72.5%, Max Risk = $115.95, Max Gain=$84.05

DIA: $263p/261p – 2 Contracts – Open 8/15 – Expires 8/30 – Net Premium = $263.05
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 27.1%, ROC = 202.3%, Max Risk = $130, Max Gain=$270.00

This Spread traded began 7/25 when DIA was trading around $272.50. The probability of OTM was initially above 80% and my $360 but at risk seemed reasonably safe. Until a Trade-Tweet caused the market to reel, Then at the expiration date of 8/16, this trade was deep ITM and incurred the max loss unless I did something to mitigate.

The Market had two other US/China Trade-Tweet related tantrums this year, and both times it took about six weeks to recover. Being four weeks into the downturn, I guesscided (a decision based on a gut guess) to Vertical Roll this trade for two weeks and hope for recovery enough to expire worthless.

My Vertical Roll consisted of closing the existing Spread for the max loss of $353.90 (-$340 – $13.90 trade fees to open then close) and then open a new Spread trade with the same deep ITM configuration for a big credit of $268 ($270 – $2.00 trade fee). This new trade had a new expiration date of 8/30. So my running total for this trade this far was -$47.90 (-$353.90 to close one trade + $268 to open the new trade + $40 premium collected on the first trade).

Fortunately, DIA closed at $264.13 on 8/30, and this last leg expired worthless. Therefore, my net loss on this effort was only $47.90. HUGE improvement over the initial loss.

Trades Still Cooking

IWM: $151p/$148p – 1 Contract – Open 9/6 – Expires 9/20 – Net Premium = $102.00
(Vertical Bull Put Credit Spread)
When Opened: Probability of OTM = 80.4%, ROC = 8.5%, Max Risk = $271
Now: Probability OTM = 34.5%

This trade is a second Vertical Roll from the original Spread traded that ended 8/16. At the end of last week, IWM closed at $149.9 with the short leg ($251) still in the money. Left alone it would have been assigned and higher fees charged. Closing this trade and walking away, I would have an effort loss of -$58.95.

Rolling the dice, I decided to make another vertical roll trade to expire 9/20. This new trade is still a high-risk decision, but if IWM can go up to $151 to close worthless, then this roll decision will make a profit for my effort.

SPY: $277p/$272p – Open 8/9 – Expires 9/06 – Net Debit = 40.05
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 82.2%, ROC = 8.8%, Max Risk = $454
Now: Probability OTM = 93.6%

IWM: $151c/150c – 1 Contract – Open 8/20 – Expires 9.13 – Net Debit = -$61.95
(Vertical Bull Call Debit Spread)
Open: Prob. ITM = 43.4%, ROC = 78.6%, Max Risk = $61.95, Max Gain=$44.00
Now: Probability ITM = 33.8%

DIA: $263c/262c – 1 Contract – Open 8/23 – Expires 9/20 – Net Debit = -$64.95
(Vertical Bull Call Debit Spread)
Open: Prob. ITM = 43.4%, ROC = 78.6%, Max Risk = $61.95, Max Gain=$44.00
Now: Probability ITM = 55.8%

IWM: $150c/149c – 1 Contract – Open 8/23 – Expires 9/20 – Net Debit = -$61.95
(Vertical Bull Call Debit Spread)
Open: Prob. ITM = 43.4%, ROC = 78.6%, Max Risk = $61.95, Max Gain=$44.00
Now: Probability ITM = 48.2%

DIA: 273c/276c/238p/235p – 1 Contract – Open 8/28 – Expires 9/20 – Credit = $32.05
(Iron Condor)
Open: Prob. OTM = 81.5%, ROC = 12.3%, Max Risk = $261, Max Gain=$32.05

New Trades for This Week

SPY: 282p/278p – 1 Contract – Open 9/5 – Expires 10/4 – Credit = $31.05
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 82.2%, ROC = 8.6%, Max Risk = $363

QQQ: 179p/175p – 1 Contract – Open 9/5 – Expires 10/4 – Credit = $31.05
(Vertical Bull Put Credit Spread)
Open: Prob. OTM = 82.8%, ROC = 8.6%, Max Risk = $363

QQQ: 192c/191.5c – 2 Contract – Open 9/11 – Expires 10/4 – Debit= $6495
(Vertical Bull Call Debit Spread)
Open: Prob. ITM = 52.3%, ROC = 54.0%, Max Risk = $64.95, Max Gain = $35.05

This graph is showing QQQ resuming its upward trend as the 9-day SMA has now gone above the 50-day SMA. When this originally traded, the IV was 18.8% which is high within my frame of reference but appears to be falling. But even at 18.8% the possible gain ($35.05 – $6.95) = $28.1 max profit. This $28.10 is less than the $31.05 premium received from the Credit Spread made last week.

This spread is also a .50 strike width. I, therefore, purchased 2 contracts

Epilogue

The one critical info missing from this IV post is “how do I know if the IV is high or low”? I guess I’ll work on that later.

Cheers…