The VIX was languishing near 15 heading into the Labor Day weekend. At the same time, the implied volatility rank of nearly every ETF I follow was below the 25th percentile. So, yeah, volatility is low. Does that mean we should buy options?
It depends!
Here’s what most people learn about buying versus selling options when it comes to implied volatility:
- Low IV = Options are Cheap = Buy Them
- High IV = Options are Expensive = Sell Them
Both statements are generally correct, but you must consider other factors when it comes to strategy selection. If you want a comprehensive overview of all I consider, then read this Trading Justice Newsletter.
Here’s what I want to emphasize today.
First, you can still sell options in a low IV environment.
Second, there’s a difference between cheap and underpriced.
Third, when flipping from selling to buying options, you drastically change the probability of profit.
Selling Options in a Low IV Environment
Low IV is not automatically a deal breaker for selling options. As long as I can get an acceptable premium for the distance OTM that I’m selling, I will do it. For example, the IV rank for the Russell 2000 ETF (IWM) is 15%. And yet, I sold an Oct $205 naked put for $200.
Why?
Because a) it was a 7% ROI in a margin account or (1% ROI in a retirement account), b) It was around 10% OTM, and c) I was a willing buyer of 100 shares.
Would I have loved to have sold the put for $400? Sure! But it wasn’t available, so I had to settle with $200. Remember that the market is efficient. The reason why IV gets low and premiums shrink is because the market is moving less. Actual volatility is going down. Thus, options premium fall to adjust. The reality is I don’t deserve $400 for selling a 10% OTM put in IWM. There simply isn’t enough perceived risk right now to justify that type of payday.
The Difference Between Cheap & Underpriced
It’s possible for an option to be both cheap and overpriced. When it comes down to it, I sell options because they tend to be overpriced. If I sell an option on SPY when the VIX (which is IV) is at 15%, what do you think it means if over the duration of the trade SPY only realizes a 10% volatility? It means the option was overpriced!
Technically, an option is only underpriced if the stock moves more than the IV priced in. Here’s how I’d think about it.
- If IV > realized vol over the trade duration, then the option was OVERPRICED.
- If IV < realized vol over the trade duration, then the option was UNDERPRICED.
Changing Probabilities
If I could easily switch from selling to buying options while maintaining a high probability of profit, then perhaps I’d find the idea more appealing. But I can’t! This, perhaps more than anything, is why I find it hard to pull the trigger on long calls or puts (or call/put debit spreads). Sure, you can rest easy knowing you entered with a low IV, but your POP just got torpedoed if you purchased that call instead of selling naked puts.
At the same time, you also shifted aggressively from theta to delta. Instead of cash flow driving your profits, direction is at the wheel. And with that comes far less margin of error.
In sum, it’s a gross oversimplification to assume you must buy options in a low IV environment. You can do it, sure, but don’t pretend like there aren’t a ton of other variables you must consider.
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