After a brutal year in 2022, the S&P 500 (SPY) rallied higher to start the year only to give back much of the gains. Using a steady hand to steer through daily volatility is still a very viable strategy. 2023 is evolving into a stock pick market. A simple system of taking profitable bullish positions in good stocks AND simultaneously taking bearish positions in bad stocks makes more sense than ever. That kind of balanced approach is likely to outperform even in what is expected to be a difficult 2023. Read below to learn more.
options. Implied Volatility. Many traders’ eyes glaze over trying to understand what is far too difficult to ever comprehend.
In reality, however, the concepts that make up options trading are easier to grasp than you think.
A tour of what I think is the most important concept, implied volatility (IV), will help you prove it.
The most widely used measure of implied volatility is the CBOE Volatility Index (VIX). It measures the 30-day implied volatility for the S&P 500 Index.
Many of you are probably familiar with the VIX because it has been discussed on the major financial news networks. In fact, I talk about the VIX weekly on CBOE-TV “Vol 411”.
People look to the S&P 500 as a benchmark for how stock prices are doing in general. Similarly, options traders look to the VIX as a benchmark for how option prices are performing.
A higher VIX means more expensive options. A lower VIX means option prices are cheaper. So implied volatility is just a fancy way of saying “the price of the option”.
Implied volatility can be thought of the same way as insurance premiums:
- Safe and consistent drivers have lower car insurance premiums. Safe, stable, and less volatile stocks have lower option premiums.
- Crazy and reckless drivers have much higher rewards. Wilder stocks with higher volatility have much higher option premiums.
So it’s not surprising that option prices are referred to as option premiums and that many portfolio managers buy downside puts as insurance to protect their portfolios from lower prices.
There are six components used for pricing options:
- Stock price
- exercise price
- expiry date
- Current interest rate
- Dividends (if any)
- Implied Volatility (IV)
The first five are known. You can look at your trading screen and see the stock price, strike price, days to expiry.
Interest rates and dividends are easily found with a Google search. The only unknown is implied volatility.
As mentioned earlier, implied volatility is simply the price of an option. There is no need to do the fancy math or calculations shown below to understand IV.
Implied volatility is called implied because it is the volatility input required to adjust the option’s price to the price it is currently trading at. A look at Microsoft (MSFT) Options shows the implied volatility for the different strike prices.
Notice how different strikes with the same expiry date – in this case April 21st – have different implied volatilities. This is called option distortion.
A key takeaway is that out-of-the-money puts almost always trade with higher implied volatility compared to similar out-of-the-money calls.
The MSFT $230 puts have an IV of 30.60 while the $265 calls are much lower with an IV of 26.27 as shown in red.
Both options closed about $17.50 points out of the money. Out-of-the-money refers to the difference between the stock’s trading spot and the strike price.
Puts are out of the money when the strike price is below the current stock price. Calls are out of the money when the strike price is higher than the current stock price.
In this case, the $230 puts were 17.27 points below Microsoft’s close ($246.27 to $230) — or out of the money by that amount. The $265 calls were $17.73 points out of the money.
The main reason for this IV difference is the fact that stocks tend to fall faster than they rise. Puts down are therefore more valuable than calls up.
Implied volatility tends to be much higher ahead of earnings and other corporate events. This makes sense as there is a potentially large movement in the stock price ahead.
Implied volatility typically decreases after the earnings release or company announcement when the unknown emerges.
A better understanding that high implied volatility means higher option prices can be crucial when considering potential trades. Paying a higher option price means you need a larger movement in the stock to justify the trade.
In my POWR options service, I always perform in-depth analysis of implied volatility, along with using POWR ratings and technical analysis as part of the idea generation process.
It is just as important for individual traders to always consider the level of implied volatility when looking at their trades.
Implied volatility as a market timing tool
Implied volatility can be used to identify potential turning points in the market. This is especially true when implied volatility spikes.
The charts below show the VIX on top and the S&P 500 (SPY) on the bottom. Notice how the previous spikes in the VIX (highlighted in blue) ultimately signaled significant short-term lows in the S&P 500.
Long periods of low levels in the VIX are a sign of complacency, which are usually a reliable indicator of short-term market tops, as seen in purple. The recent sell signal was a sign of this.
Warren Buffett’s old adage of “be fearful when others are greedy and greedy when others are fearful” applies perfectly to this VIX market timing methodology.
As we know, trading is all about probability, not certainty. Understanding and using implied volatility to turn these probabilities in your favor can be a valuable addition to your trading toolbox. At POWR Options, it’s one of the most important tools we use.
What do you do next?
If you’re looking for the best options trades for today’s market, be sure to check out this essential presentation on options trading with POWR ratings. Here we show you how to consistently find the best option trades while minimizing risk.
Using this simple yet powerful strategy, I have delivered a market-beating return of +55.24% since November 2021 while most investors were in heavy losses.
If this appeals to you and you want to learn more about this powerful new options strategy, click below to access this updated investment presentation now:
How to trade options with the POWR ratings
Good trade!
Tim Biggame
Publisher, POWR Options Newsletter
SPY shares were up $0.24 (+0.06%) after the close on Friday. Year-to-date, SPY is up 5.69% versus a percentage gain for the benchmark S&P 500 index over the same period.
About the Author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as a Market Maker for First Options in Chicago. He is a regular on Bloomberg TV and writes Morning Trade Live weekly for the TD Ameritrade Network. His overriding passion is making the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR Options newsletter. Learn more about Tim’s background and links to his latest articles.
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