Concocting the Short Strike for a Vertical Credit Spread using Implied Volatility (IV) is not so nutty.
Alaskan Polar Bear Heater
Some scotch, 2 shots of vodka, a little rum, some bitters, a smidgen of vinegar, a shot of vermouth, a shot of gin, a little brandy, a lemon peel, orange peel, cherry, more scotch, mix it nice, pour it into a tall glass
– Buddy Love (Movie: Nutty Professor (1963))
Implied Volatility with Vertical Spreads
When I first started Options trading, 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 few years selling Vertical Credit Spreads, I can confidently say, “I still don’t have a clue, but I do have an appreciation!” And like the Alaskan Polar Bear Heater, Implied Volatility (IV) requires a lot of ingredients.
This week’s Journal Entry is not so much about a bowl of delectable Christmas punch, but a brief review of one of the derivatives of the heaters, Implied Volatility.
Commentary Content
- What Is Implied Volatility?
- What Is Volatility?
- How To Get Future Stock Prices?
- What is Black-Scholes-Merton?
- What Is Standard Deviation?
- English Please!
- Final Consideration
What Is Implied Volatility?
Implied Volatility (IV) is basically, the value of the volatility of the underlying stock or ETF that the Option is based on. When IV is used with a pricing model (such as Black-Scholes-Merton) it will help calculate a theoretical value of the Option’s premiums. Thus, if the underlying’s volatility goes up, the Option’s premium price goes up as well. And, if the volatility of the underlying settles down, so does the premium price.
What is Volatilty?
Volatility is the degree to which the stock’s price changes over a short period of time. In the realm of the Option-Verse, volatility is usually denoted by the Greek symbol Sigma (σ). To calculate volatility (Sigma), I have to collect a series of stock prices, then determine its standard deviation value from that series.
If the series of stock prices that I collect covers the past 30-days, then the Standard Deviation value is called “Historical Volatility” (duh, it covers past actual prices). But if the collection covers 30 days in the future, then the Standard Deviation is called “Implied Volatility” (implied what the future values could be).
How To Get Future Stock Prices?
No one can get the future prices of stocks. But we can tap into the collective mentality of the Marketeers.
With millions of investors (big and small) making hundreds of millions of stock transactions every day, we can ask them what they believe a stock value might be in 30 days from now. I can guess this by looking at all the Call Options (with a 30-day expiration date) that have been sold.
Call Options
One way to determine the implied future value of a stock is to see what millions of other Investors are buying.
Just looking at the list of current 30-day Call Options in my thinkorSwim Options Chain, I can see that there are hundreds of thousands of open orders (Open Interest) wanting to be bought/sold. If I can download and collect this information in my spreadsheet I can then easily calculate what is the most popular Strike Price. But popularity is not accurate enough.
If I want to do a better job in figuring out future prices, I need to calculate the Implied Volatility (IV) for each and every Strike Price in my collection. I can do that by comparing the number of open orders for one Strike Price (again, 30-day expiration) and balancing that with the number of orders for another Strike Price. And I can make sense of that concoction by running all these numbers through my Standard Deviation engine.
But luckily for me, instead of all this math I can just glance at the ThinkorSwim’s Options Chain and find all this information there.
What Is Standard Deviation?
Standard Deviation is a nerdy statistical calculation that will run through a collection of data points and create a table of probabilities. Without going into how it’s done, the resulting table will resemble a curve, where 68.2% of all the values will fall within 1 Standard Deviation (SD) of the collection’s mean, 27.2% of all the values will fall between 1 and 2 SDs, and so on.
What Does a High Standard Deviation Mean?
If a stock (strike) price has a large standard deviation value, then there is a lot of price variance as it surrounds the collection means – the bell curve is spread out. A small or low standard deviation would indicate instead that much of the data observed is clustered tightly around the mean – the bell cure is squashed together.
Implied Volatility is the value that determines just how wide the Standard Deviation curve is.
What is Black-Scholes-Merton?
The mysterious VooDoo equation behind setting the price of an Option is the impressive Black-Scholes-Merton Model. This equation requires lots of liquor and large parts of vermouth. But as scary as the BSM is, it is regarded as one of the best ways for pricing an Options Contract.
The BSM model uses the stock price, strike price, days until expiration, interest rate, dividends, and the Implied Volatility of the stock as variables in the equation. By using IV in their equation, they can add little external real-world influences that can quickly change the cost of stocks.
English Please!
This post is my high-level understanding of Implied Volatility and how I should view this as one of my matrixes.
As a stock’s (or the broader market) uncertainty rises and falls, so does Implied Volatility (IV). And since IV steers the premiums I can collect when selling a Vertical Put Credit Spread, keeping an eye on IV will help me choose the best Short Strikes for my Spreads.
How to use Implied Volatility
- 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. I can do this by selling the Short Strike 1 or 2 Standard Deviations below the current underlying’s price.
- 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.
Short Strike Entry Strategy
I can use IV to help select the Short Strike price by using the equation below. This suggested Strike Prices 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 a Dec 23, 2021 Option for a hypothetical ETF: XYZ
- Days to expiry = 26
- Current XYZ price = $268.32
- Current IV at $268.32 = 15.99%
- Price difference at 1-SD from current price = 268.32 * .1599* sqrt(26 / 365) = +/- $11.45
- ETF price 1-SD below current price ($268.32 – $11.45) = $256.87
- Next Strike below $256.87= $255
- Suggested Short Strike for a XYZ Vertical Put Credit Spread = 255
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 XYZ will remain above the Short Put strike of $255.
Final Consideration
Although Implied Volatility is billed as a forward-looking matrix. It is only forward-looking as far as what the Marketeers believe today. And what they believe today is based on yesterday’s dynamics. Any ETS that happens in today’s news will change all Implied Volatility at a drop of a hat.
Other Posts from Options Trades By Damocles
This Week’s Market Sentiment
This Market Sentiment Section is typically completed by midday Monday morning. By the time this journal is published, it will be a week old.
(As of 12/05/2021)
In this section, I review five indicators: VIX, Put/Call Ratio, S&P 500, Consumer Sentiment Index, and Geopolitical events that could affect the market’s direction. I will use these indicators to help guide my trading decisions for this week.
Each of my five indicators will “vote” on a DEFCON (Damocles Options Trading Readiness Signal) level, exclusive to that indicator. Then, In the final sub-section “My sentiment for this coming week” below, I’ll compile the votes into a DEFCON level for the week.
ecopolitical Tree Shakers:
Ecopolitical (Sociopolitical-Economics) Tree Shakers (ETS) can be breaking news, political machinations, Federal Reserve musings, or even Twitter Trends. They are events that can abruptly change the dynamics of the current markets.
ETS is like a lit fuse to a bomb. The fuse can be fast or slow, and the bomb can easily be a dud. But I need to watch this closely as an indicator. The ETS can significantly disrupt all the other indicators at the drop of a hat.
- Winter of death! Omicron is getting political
- Feds increased pace of tapering at December’s meeting – expect early start to aggresssive interest rates
- Joe Manchin officially said no to BBB
- End-of-Year typical selloff
The Grinch Who Stole Christmas
A grim warning came from the White House, as President Biden declared the “Winter of Death” is coming. I’m predicting his dark Biden prediction will define him in history, trumping Jimmy Carter’s Malaise Speech.
So far, the severity of the Omicron variant is thought to be mild, but the sheer volume of expected infection is predicting catastrophe (“Winter of Death”). The Netherlands went into full lockdowns that started Sunday and will last until mid-January. The UK is also considering implementing restrictions. The US is not stating a return to 2020, but the signals are there. I expect markets to roil from any lockdown news until more information about the virus is discerned.
The 2020 pandemic stimuli ignited rampant inflation by handing out trillions of dollars to millions of people (to help sustain those who will lose their incomes during the coming lockdowns). But with the lockdowns, the supply chain collapsed because we stopped back-filling of products that needed to be in the queue to move. This collapse forced the price of products on the shelf higher since there was now less supply to sell, sending the price of available goods through the roof. Now the Feds now has to resort to their go-to inflation fighter – high-interest rates.
Raising the national Discount Rate will quickly make available goods even more expensive as it will now cost more to borrow and keep businesses running. Higher prices will slow down the rate we are buying stuff. With even higher prices, fewer goods will be bought and the forces of supply-and-demand will push prices down.
On this past Sunday’s talk shows, Senator Joe Manchin stated that he will not support the epic Build Back Better spending bill. Stating that he gave it his best shot, but could not support such a huge bill with the ongoing inflation, national debt “geopolitical unrest,” and the COVID pandemic.
I’m starting to see a collective sigh of relief as many of our economic pressures find release valves. But any announcement from the Feds on raising interest rates can turn the markets sour in the short term.
I also do expect the fearmongering to ratchet up as the 2022 mid-term elections start to heat up. But I feel better about the next 6-8 weeks than I did a couple of weeks ago.
ETS votes a DEFCON 4
VIX: Broad Market Volatility
The VIX is an emotion-gauge for the general investing population. It is thought to be driven by the Marketeers’ current level of greed or fear. As one-month forward-looking volatility, it is not designed to tell us which direction the market will be going, but more of how fast it can get there.
A VIX of 15% is assumed to be a market at rest. Since the intrinsic nature of the Stock Market is to move up, a VIX close to 15% or below will correspond with the market’s innate tendency to rise.
The trajectory for the 1-month VIX Regression Channel looks to be taking a collective breath as it ended last week at 22%, slightly up from 19% the week before. Leveling within striking distance from 15%, I still see this as the Marketeers being strained over the current market sentiment – but hopeful.
With the VIX now over 20 but appears to be dropping suggests continued indecision on what the next step should be. The Biden Administration is raising the Omicron Fear-Flag, so depending on what he said in his Oval Office speech this Tuesday will probably drive the markets for the next several weeks.
Being blind to all other indicators, I will vote for a cautious DEFCON level 4
VIX votes a DEFCON 4
Put/Call Ratio:
Put Options are frequently used as protection against existing investments falling. When the ratio between Put Options bought versus Call Options bought is above 1, then this is an indicator that the Marketeers are buying insurance to what they may see as declining Markets. Conversely, when the Put/Call Ratio falls below 1, then there is a general sense that the broader Markets will increase, and more investors are buying more than selling.
The S&P 500 Put/Call Ratio has settled a bit from the wild ride over the previous weeks.
Ending with .62 this past Friday, the Put/Call Ratio is much closer to .5 than it is to 1.0. This suggests to me that the Marketeers are still in a buying mood but feeling a bit nervous.
Put/Call Ratio votes a cautious DEFCON 4
Consumer Sentiment Index (CSI):
A low CSI index is a general dissatisfaction with our current management of U.S. economic policies. This dissatisfaction will imply that something has to change. A high satisfaction rating suggests approval of the current policy management and implies market stability. Surveys of Consumers (umich.edu)
Last week’s CSI had a surprising bounce from 67.4 to 70.4. Not a good level overall, but a decisive move in the right direction. Inflation is probably the biggest drag to the index, but it appears the Omicron news is being shrugged. This may change with the Omicron wind.
Being blind to all other indicators and just looking at this week’s CSI, I feel we should be extremely cautious.
CSI votes a DEFCON 3
Market Indexes:
DOW (DJX) = 35,365 – down 1.7% from 35,971 last week. (4 weeks deviation: 549 down from 608 last week)
S&P 500 (SPX) = 4,621 – down 1.9% from 4,712 last week. (4 weeks deviation: 59.33 down from 61.18 last week)
The S&P 500 is a stock market index that tracks the 500 largest companies in the U.S. This index represents about 80% of all the capitalization for the country. The S&P is widely considered the best indicator of how all the U.S. markets are performing.
Market Thrashing
4 Weeks Thrashing of DJX = +/- 549 points or 1.6% of the market’s volume is slightly down from 1.7% last week.
4 Weeks Thrashing of SPX = +/- 59.33 points or 1.3% of the market’s volume is flat from 1.3% last week.
(Market Thrashing above 1.0% might indicate indecision from the Marketeers.)
The broader markets had a tough week last week, losing fairly big on a Friday selloff. But December is typically hard because of the end-of-the-year taxes and dividends payouts.
The two-week trajectory moved bullish, as the severity of the projected market beatings did not pan out.
If the long-term markets are decisively bullish but thrashing is too high, but there still appears to be some guesswork over the remainder of this year.
Being blind to all other indicators and just looking at current market trends I will continue to vote for DEFCON 4.
Market Index votes a DEFCON 4
My sentiment for this coming week:
Of the five indicators:
- The ETS is showing improving content – DEFCON 4
- The VIX falling sharply – cautious DEFCON 4
- The P/C Ratio shot up over 0.8 – cautious DEFCON 4
- The CSI shows a consumer base not excited about our economic future – DEFCON 3
- The Market Movement rebounded from November selloff – DEFCON 4
I still think that December is going to test my resolve, but a turnaround with the ETS and Market Movement is suggesting that a lowering of temperature is up ahead.
Trading Readiness Level for this week
This week, I will focus on:
This week is a wait-and-see on what the Feds will do about inflation. Therefore, my markets expectation is several weeks in moderation with thrashing and moving mostly sideways or up.
At DEFCON 4 I will set my POTM sights as follows:
- Enter into new Spreads for a total market risk this week of < $3K (as the Markets see fit)
- Open 1 30-wide Strike-Width Spread or 2 20-wide Spreads.
- Select the Short with POTM >= 85%
- Spread term of 8-weeks or less
Profit and Loss Statement
(As of 12/23/2021)
Balance Sheet
| Year 2021 | Month Dec | Week #51 | |
| Beginning Account Balance | $16,000.00 | $20,342.72 | $20,653.64 |
| Deposits (Div. & Int.) | $1.61 | $0.00 | $0.0 |
| Withdraws (paycheck) | -$3,300.00 | -$0.00 | -$0.00 |
| Premiums on Open | $9,188.01 | $442.00 | $122.00 |
| Premiums on Close | -$1,118.00 | -$5.00 | -$0.00 |
| Fees Paid (total) | -$117.98 | -$3.06 | -$1,92 |
| Ending Account Balance | $20,776.66 | $20,776.66 | $20,776.66 |
| Total Gain/Loss | $4,653.64 | 433.94 | $123.02 |
| ROR | 2.1% | 0.6% | |
| ROC | 29.9% |
Progress Graph
(Note: the negative weekly results for weeks 4, 8, 12, 17, 21, 25, 30, 34, 38, 43, and 47 are when I withdrew $300 from the Trading Account for my paycheck.)
My Performance vs. SPY
Hypothetically, instead of depositing $16,000 in my Options Trading Account, could I have done better if I bought $16,000 of the ETF/SPY instead?
| Options Trading Account | SPY (Fictional) | |
| Initial Investment (As of Jan 4, 2021) | $16,000 (Cash) | $16,000 (43.39 shares @ $368.55) |
| Funds Added | $9,311.62 (Premiums) | 0.59 shares (Dividends Reinvested) |
| Funds Removed | -$1,234.96 (Early Close & Fees) | $0 (Fractional Shares Sold) |
| Ending Balance | $24,076.66 (Cash) | $20,687.44 (43.98 shares * $470.44 CV) |
| ROI | +50.5% | +29.3% |
Schedule for this Week
Goals for this week: (12/20/2021 – 12/23/2021) (Week #51)
- Document lessons learned or new thoughts
- Open one or two wide-strike spread
- Update Trading Log as trades occurs
Monday:
- Determine/update this week’s market sentiment section
- Calculate/record Put/Call Ratios for all stocks on the watch list
- Review/tweak Trend-Channels for all stocks in the watch list
- Set target expiration dates for all Options as follows:
- Bull Credit Spreads: Feb 11, 2022 (6-8 weeks)
Note: If there are no Options Chains published for the 8-week expiration, then use the next Options Chain down from 8-weeks (7-weeks, 6-weeks). Beyond 4-week expirations, only the monthly chains are available to trade.
- Bull Credit Spreads: Feb 11, 2022 (6-8 weeks)
- Look up Ex-Dividend dates for positions in/approaching ITM (MarketWatch/Calendar)
- Stage possible trades for all watch list stocks by 10:00 AM
- NO TRADING BEFORE 10 AM. (Let the Market find its direction after the weekend.)
- Watch one Webcast or take one online mini-course to be completed by Friday.
Tuesday – Thursday:
- Review how yesterday’s staged trades moved. Adjust premiums to take advantage of movements.
- Submit a couple of Spreads, but keep a close watch. If one is accepted, cancel the others (we want only one new active trade per day).
- Be mindful of Entry Rules.
Friday:
- Review the total technical dollars at risk for this week. If significantly below $500, then submit additional spreads if prudent.
- Update and post weekly journal (this blog) with any lessons learned or strategy changes.
This Week’s Trade Activity
(As of 12/23/2021)
Spread Count Summary:
| Year 2021 | Month Dec | Week #51 | |
| Vertical Bull Put Credit Spread | 83 | 4 | 1 |
| Vertical Bear Call Credit Spread | 0 | 0 | 0 |
| Vertical Bull Put Debit Spread | 0 | 0 | 0 |
| Vertical Bull Call Debit Spread | 0 | 0 | 0 |
| Margin Interest | 1 | 0 | 0 |
| Total | 84 | 4 | 1 |
Current Dollars at Risk:
| Year 2021 | Month Dec | Week #51 | |
| Vertical Bull Put Credit Spread | $15,358. | $9,558. | $2,878. |
| Vertical Bear Call Credit Spread | $0. | $0. | $0. |
| Vertical Bull Put Debit Spread | $0. | $0. | $0. |
| Vertical Bull Call Debit Spread | $0. | $0. | $0. |
| Iron Condor | $0. | $0. | $0. |
| Total Dollar Risk | $15,358. | $9,558. | $2,878. |
| Max Risk Allowed | $16,000. | N/A | $3,000. |
Vertical Spreads Opened This Week
(12/20/2021 – 12/23/2021)
DIA:320p/290p – Open 12/21/21 – Expires 01/28/22 – Max Gain = $122.00 – Open Price = $352.64
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=85.3%, Headroom-9.3%, Max Loss=$2,878, AROR=40.4%
Entry Rules for Vertical Bull Put Credit Spreads:
- Current maximum dollars at risk < $16,000? Yes ($15,358)
- Max dollar at risk this week < $3,000? Yes ($2,878)
- Max time to have any dollars at risk < 8 weeks (<56 days)? Yes (38 days)
- Long-term trend (four months) bullish? Yes (see chart)
- Short-term trajectory of the underlying bullish? No (see chart)
- 2-week Thrashing < 1.0: Yes (0.9%)
- Put/Call Ratio < 1, (or falling if it is > 1)? Yes (0.7 down from 2.1)
- Current price above 9-Day SMA?: No (see chart)
- 9-Day SMA above 50-Day SMA?: Yes (see chart)
- Short-strike > 1 SD below the current price? Yes (1SD=$328.38)
- Short-strikes Prob-OTM > 85%? Yes (85.3%)
- Short-Strike price below the trend channel at expiration?: Yes (see chart)
- Current price within the bottom 1/2 of Trend Channel?: Yes (see chart)
- Strike Width minimum (>= 15)? Yes (30 strike width)
New to the above Entry Rules is the “2-week Thrashing” indicator. The narrative is, if the short-term thrashing is high (> 1.0), and the IV percentage is above 15%, then the Marketeers are mostly non-committed to the current short-term trajectory. Therefore, I then should not be supersized if the markets abruptly change directions.
On the flip side, if the short-term thrashing is low < 1.0%, and the IV percentage is below 15%, then the Marketeers are fairly comfortable with the current short-term trajectory. In this case, barring any earth-shattering changes in the market-verse, the current trajectory should continue.
Vertical Spreads Currently Cooking
(As of 12/23/2021)
SPY:425p/395p – Open 12/15/21 – Expires 01/28/22 – Max Gain = $141.00 – Open Price = $470.18
(Vertical Bull Put Credit Spread)
Now: Prob. OTM=81.1%, Headroom=-7.6%
IWM: 195p/180p – Open 12/09/21 – Expires 01/21/22 – Max Gain = $95.00 – Open Price = $222.37
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=84.0%, Headroom-12.3%, Max Loss=$1,405, AROR=56.8%
Now: Prob. OTM=80.4%, Headroom=-9.4%
QQQ: 330p/305p – Open 12/01/21 – Expires 01/21/22 – Max Gain = $87.00 – Open Price = $399.23
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=91.4%, Headroom-17.4%, Max Loss=$2,411, AROR=26.0%
Now: Prob. OTM=90.5%, Headroom=-14.3%
SPY: 415p/385p – Open 11/23/21 – Expires 12/31/21 – Max Gain = $82.00 – Open Price = $468.17
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=90.3%, Headroom-11.3%, Max Loss=$2,918, AROR=26.7%
Now: Prob. OTM=95.8%, Headroom=-9.8%
QQQ: 340p/310p – Open 11/11/21 – Expires 12/31/21 – Max Gain = $1.15- Open Price = $391.45
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=88.6%, Headroom-13.1%, Max Loss=$2,886, AROR=28.6%
Now: Prob. OTM=95.3%, Headroom=–11.7%
Vertical Spreads Closed This Week
(As of 12/23/2021)
SPY: 420p/390p – Open 11/18/21 – Expires 12/23/21 – Max Gain = $0.73 – Open Price = $469.01
(Vertical Bull Put Credit Spread)
At Open: Prob. OTM=91.1%, Headroom-10.4%, Max Loss=$2,927, AROR=27.7%
At Close: Prob. OTM=98.6%, Head Room=-8.7%, AROR= 27.7%
Cost to open: $0.73 premium collected * 100 shares = $73.00
Cost to close: $0.00 premium paid * 100 shares = $0.00 (closed worthless)
Net Profit= $73.00 to open – $0.00 to close – $1.00 fees = $72.00
AROR= ($72.00 / 35 days in play) *365 / $2,927 = 27.7%
The opening price for SPY was $469.01. The price fell to $459.87 or nearly 2%. Yet, even though SPY closed lower, this Spread is still a winner.
Conclusion
Can selling options for income be considered a Home Business? Can I make money at home by selling Vertical Bull Put Credit Options Spreads? These are questions that I am trying to answer for myself.
Three years ago, I set out on a task to see if I can make a retirement income from home by trading Stock Options. I began with NO knowledge of Options mechanics and only $8,000 to risk. And because I learn best when I write things down, I have documented every step of the way (every bonehead mistake, process epiphanies, interconnecting events, externalities, and so on).
This blog is my Options Trading Journal. I will record my weekly Option Contracts buys and sells in hopes of gaining experience.
Experience is the ability to recognize that
– Damocles
I’m about to make the same mistake again.
Disclaimer
Even though I have tried to make it clear that this blog is my personal trading journal, it has been suggested by others that I, nevertheless, include a general disclaimer. So here goes…
“This blog and the information contained herein is not intended to be a source of advice or analysis concerning the material presented. The information and/or documents contained in the blog do not constitute investment advice.”
No comments! Be the first commenter?