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Don Kaufman here. |
Today we're diving deep into one of my favorite topics: volatility. |
If you listen to the main stream media they'll always tell you how investors hate volatility and uncertainty. |
But the truth is, traders thrive off it. And if you want to be successful at trading options, then you must understand the basics of volatility. |
So let's get down to business and explore how you can use volatility to take your options trading to the next level. |
Understanding Implied Volatility |
First things first, we need to understand that options are essentially markets on future risks of an underlying product. |
When you're trading options, you're not just betting on direction; you're trading volatility itself. It's like buying or selling insurance against market moves. |
The options market places a price tag on risk, and that's where implied volatility comes into play. Implied volatility (IV) is the market's forecast of a likely movement in a security's price. |
It's the crystal ball of the options world, but instead of magic, it's based on cold, hard math and market sentiment. |
Implied volatility is set by supply and demand in the options market. If traders are buying a boatload of options, prices go up, and so does implied volatility. |
This often happens when market participants are nervous or uncertain about future events. |
On the flip side, if there's a lot of selling pressure, supply increases, and implied volatility drops. This typically occurs when the market is calm or complacent. |
Now, let's talk about a fascinating phenomenon: what happens to implied volatility leading up to an earnings event. |
As we approach earnings announcements, we often see a rise in implied volatility. |
Why? |
Because earnings reports are like Christmas morning for traders - you never know what you're going to get! |
This uncertainty leads to increased demand for options as traders look to either protect their positions or speculate on potential big moves. |
Interestingly, once the earnings are announced, we often see a dramatic drop in implied volatility. This is known as "volatility crush." |
The uncertainty is resolved, and suddenly those options aren't worth as much anymore. It's like the air being let out of a balloon. |
But what about when the market sells off hard? That's when things get really interesting. |
During sharp market declines like we have seen over the last month, we typically see a spike in implied volatility. |
This is often referred to as the "fear gauge" of the market. And that brings us to our friend, the VIX. |
The VIX, or the CBOE Volatility Index, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. |
It's derived from the price inputs of the S&P 500 index options. When the market is selling off, the VIX tends to spike. |
During calm periods, it stays low. A VIX reading above 20 is generally considered high, while below 12 is considered low. |
But wait, there's more! |
Enter the VVIX, or the "volatility of volatility" index. The VVIX measures the volatility of the VIX itself. It's like looking at the turbulence of the turbulence. |
When the VVIX is high, it indicates that traders expect large swings in the VIX, which often precedes or coincides with major market moves. |
Personally, I prefer VVIX over VIX when I am watching for volatility in the market. |
During periods of market stress, we often see both the VIX and VVIX spike. For example, during the COVID-19 market crash in March 2020, the VIX hit an all-time high of 82.69, while the VVIX surged above 200. |
This combination indicated extreme fear and uncertainty in the market. |
Understanding these dynamics of implied volatility can give you a significant edge in your options trading. |
It allows you to anticipate potential changes in option prices beyond just directional moves in the underlying asset. |
Whether you're looking to sell premium during high IV periods, buy options when IV is low, or simply protect your portfolio during volatile times, a solid grasp of implied volatility is crucial. |
Remember, in the world of options, volatility isn't just something to be feared - it's an opportunity to be seized. |
Master the concepts of implied volatility, and you'll be well on your way to becoming a more sophisticated and successful options trader. |
The Skew: Your Secret Weapon |
Now, let's talk about something that might sound fancy at a cocktail party but is crucial for your trading: skew. |
Skew is the differential or disparity in implied volatility between in-the-money and out-of-the-money options. In simpler terms, it's the shape of the volatility curve across different strike prices. |
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In index and index-related ETFs, where does the greatest risk often reside? That's right, to the downside. |
This fear of downside moves creates a natural skew in the options market, with out-of-the-money puts often having higher implied volatility than out-of-the-money calls. |
In my in/out strategy, we're taking advantage of this fear. |
We're selling those expensive out-of-the-money puts (or calls depending on what we are trading) that people are overpaying for. |
But here's the kicker - we're not being reckless. We're also buying puts even further out-of-the-money for protection. That's the "in" and "out" part. |
Now, I've seen billions of data points in my time at ThinkorSwim, and let me tell you, this strategy works. |
It's not going to make you rich overnight, but it's consistent. It's how you grow a small account into something substantial. |
Remember, we're not looking to hit home runs here. We're playing small ball, taking advantage of this skew again and again. Some trades will lose, sure. But over time, the math is in our favor. |
This is the kind of edge that the big boys on Wall Street use, and now you can too. |
It's all about understanding the market, understanding fear, and using it to your advantage—-click here to learn more about the strategy. |
So next time you're looking at an options chain, don't just see numbers. See the fear, see the skew, and see your opportunity. |
Leveraging Volatility in Your Trades |
So, how can you use this knowledge to improve your trading? Here are a few strategies: |
Sell Overpriced Volatility: When implied volatility is high, consider selling options premium. Strategies like credit spreads, iron condors, or even naked options (if you're comfortable with the risk) can be profitable when volatility is elevated. Buy Underpriced Volatility: Conversely, when volatility is low, look for opportunities to buy options. Long calls, puts, or debit spreads can be attractive when implied volatility is depressed. Exploit Skew: If you notice a significant skew in the options chain, consider strategies that take advantage of this disparity. For example, you might sell an out-of-the-money put spread while simultaneously buying a cheaper out-of-the-money call spread— which is what we do with the in/out strategy.
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Volatility is a powerful force in options trading. |
By understanding how it works and how to leverage it, you can significantly improve your trading outcomes. |
Remember, it's not just about predicting price movements; it's about understanding and exploiting the pricing of risk in the options market. |
To your success, |
Don Kaufman |
