Oh, what a difference a year makes! Last January commenced with a swift kick to the bulls’ family jewels. ‘Twas a nasty, underhanded strike designed to deliver death. And it almost did! The S&P 500’s 11% puke over the first three weeks of 2016 was the worst start we’ve ever seen. Ever!
What a nasty stat.
So far (as much as three trading days can count as “so far”) 2017 has been much better. Bullish charts are multiplying as the post-election rally catches its second wind.
With that completely unrelated intro now out of the way, let’s pivot to today’s topic: Why I don’t mind selling options even when implied volatility is low.
For the uninitiated, options traders use implied volatility to determine if option premiums are cheap or expensive. When demand for an option increases its premium swells like a ripe melon. This fattening of the option price is what drives implied volatility higher.
Takeaway: High implied volatility = options expensive
When the supply of an option increases, its premium shrinks like me before a gun-toting madman. This deflating of the option price is what drives implied volatility lower.
Takeaway: Low implied volatility = options cheap
As you might imagine the ideal time to sell options is during periods of high implied volatility. Juicy premiums allow you to score higher credits and wider profit-ranges. One problem with only selling options (and by selling options I’m talking naked puts, covered calls, credit spreads, and the like) when implied volatility is elevated is that it doesn’t happen very often. Periods of high volatility are few and far between. Worse yet, they’re fleeting. If you don’t strike while the iron’s hot, you may well have missed your opportunity.
Take 2016 in the SPY for example. I have the Implied Volatility Rank (IV_Rank) indicator displayed in the lower panel. The indicator ranges between 100 and 0 with anything north of 50 considered “high” and anything south of 25 considered “low”.
If you’ve resigned yourself to selling options only during high volatility, you had a whopping two chances to do so this year (at least in SPY). And if you blinked, you missed them.
Takeaway: The first problem with only selling options with high IV is the rarity of the opportunity.
Don’t look at shorting options with high IV as good while selling them with low IV is bad. It’s more a matter of good, better, best. Shorting options is good, period. Think of it this way: Selling options with low IV is good, selling options with mid-IV is better, and selling options with high IV is best.
The reason depressed IV shouldn’t be a deal-breaker for traders looking to sell options is because strategies like naked puts, covered calls, and bull put spreads aren’t pure volatility plays. They’re also directional. As long as you are right on direction, it doesn’t matter if you were wrong on volatility.
For example, I sold puts on XOP with its IV rank near zero. It has since lifted to 8%. Not a significant rise, mind you, but a rise nonetheless. Have I lost money? No, because I was right in direction. The stock has since rallied mildly delivering profits due to delta and theta.
Here’s the bottom line for me: If I’m neutral to bullish on a stock and considering a naked put/covered call/credit spread/iron condor. I’d love high IV, sure. But even if it’s low, I’ll still enter the trade if I can get adequate premium with a profit range I like.
Financial freedom is a journey
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