Today’s tale tackles credit spreads and volatility. Fellow team member Adam posed an interesting question I’d like to address. Check it out:

“My question is about volatility, time and credit spreads. When volatility is low, usually your credit spreads are tighter (closer to the money). Same with time, if you sell shorter term expiration, again the your spreads are closer to the money. However with low IV and a shorter time frame [the stock] is less likely to move. Contrast to selling more time and a higher IV, the stock has more time to get to your strike price or have a bigger swing due to the higher IV. If you’re selling the same delta is it not essentially the same trade with the same amount of risk?”

Let’s take a moment and let this sink in. First off, what Adam has discovered is the efficient nature of markets. There aren’t any free lunches on the Street anymore. They’ve been gobbled up by traders far smarter and faster (but not better looking, no, we have that on lock) than us. Let me share an example to illustrate what Adam is referring to. Let’s say we have a $50 stock with implied volatility at a lowly 10%. Because the expectation of risk is low, options are cheap. And that means if you want to sell a credit spread like a bull put you can’t go very far out-of-the-money. Suppose you can sell a $47.50/$45 put spread for a 10% return. And let’s say the $47.50 put has a delta of -0.15

In contrast, if this $50 stock had an implied volatility of 20% then maybe you could sell a $45/$42.50 put spread for a 10% return. In this instance, the $45 put has a delta of -0.15. Is there really much difference between the two spreads?

Nope. Not in this example. Adam is correct in thinking that both spreads are similar in probabilities, risk, and reward.

So does that mean implied volatility levels don’t matter? Before I answer that it’s worth noting that options tend to be overpriced no matter what the implied volatility is. I don’t mind selling credit spreads in low volatility environments.

Implied volatility still matters, however. First, the potential profit does tend to be higher when selling options in high IV settings. There’s more meat on the bone, so to speak. Second, option selling strategies (like credit spreads) are all negative vega, so they profit quicker if implied volatility falls over the duration of the trade. And if you enter the position when IV is high, then there’s a greater likelihood it will drop than if it’s already low.

Tyler’s personal preference: Selling options is always a good idea. It’s simply more attractive in high IV environments. I remember back in 2006/2007 when implied volatility was in the tank Iron Condors still delivered profits with uncanny consistency.

When thinking about the time to expiration, there are efficient relationships there as well. However, the 30 to 45-day time frame provides the optimal trade-off between risk and reward. Selling shorter-term is more aggressive (i.e. you make or lose money faster) while selling longer-term is more conservative (i.e. you make or lose money slower).

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