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One of the hallmarks of an options trader is the
ability to reach into his trading tool bag and pull out different trading
vehicles in order to accommodate the current market situation.
With few exceptions,
a major component of any strategy our trader would select includes selling
option premium. Premium sales usually are selected in out-of-the-money
strikes where the time (extrinsic) premium constitutes 100% of the price
received.
Examples
of pure premium sales would include being short naked puts or calls. Another
version of option premium sales would include credit spreads and iron condors
wherein premium sales are combined with selling options.
It is
important to remember that the time, or extrinsic premium of an option is
directly related to time to expiration and implied volatility in the current
0% interest rate environment.
This
current week of the options cycle is particularly difficult for two reasons.
The first reason is the result of the fact that the September monthly
expiration is one of four annual five week monthly options cycles. Remember
that there are twelve monthly option expiration cycles, a clearly obvious
fact for those possessing a calendar. What is not immediately obvious is that
since there are 52 weeks in a year, four monthly cycles must contain five
instead of four weeks.
Now
remember from our previous discussions that the time decay of option premium
is not linear. As illustrated below, time premium decay accelerates relentlessly
into the closing bell at an ever accelerating pace.
Implied
Volatility Option Trading
From a
practical level, the extra week of time in our five week cycle gives us an
extra week of relatively sluggish decay before the accelerating decay begins
to erode time premium significantly. Each week of the option cycle has
particular characteristics; living in the fifth week of a five week cycle is
like watching paint dry for traders depending on theta decay to benefit their
positions.
The next
factor that exists in our current cycle is the unusually low implied
volatility that is routinely encountered across a wide variety of underlying
assets. Let us look at the measure of implied volatility of the Russell 2000
index, the RVX. This measure is similar to the more frequently encountered
measure of volatility for the SPX, the VIX.
As can be
seen in the weekly candle chart of this volatility measure, implied
volatility is at multi-year lows.
Option
Trader Newsletter
I consider
the implied volatility to be the “stealth” component of options
trading. It has impacts far greater than expected for traders and for this
reason must be carefully analyzed in both a historic and current time frame
for each trade considered.
In order
to provide a practical example of the impact of the variable of implied
volatility, let us consider how it affects a common “bread and
butter” trade for most option traders. The trade is a “high
probability” iron condor and consists of the combination of an
out-of-the-money call credit spread and an out-of-the-money put credit
spread.
The trade
under discussion will be opened today and has fifty seven days to expiration.
The high probability of its success derives from selecting the short options
for the spread having a current delta below 10. This essentially means that
these short options have a greater than 90% probability of expiring
out-of-the-money. The trade therefore has a probability of being profitable
in excess of 80%.
For
purposes of illustration, I want to allow the magic of trade modeling to look
at this trade under two different implied volatility scenarios. Displayed
below is the comparison between the actual available trade today and the
trade that would be possible if the volatility of the calls alone were
at recent historic mean levels. I have purposely not used extreme values for
the implied volatility in order to emphasize the impact of this routinely
underestimated factor.
Implied
Volatility P&L Graph
The curves
above represent the expiration P&L graphs of the same trade taken at more
normal volatility levels (the higher curve) and current volatility levels
(the lower curve). The benchmark for comparison I have used is the annualized
yield. The seemingly small modification of increasing implied volatility of the
calls alone doubles the annualized trade yield from 80% to 160%!
I am a
realist and understand that if we wish to trade, we must live in the world we
are presented. The point of today’s missive is to call attention to the
fact that what seem to be minor factors of trivial impact can have huge
results on overall trading results.
Happy
Trading!
JW
Jones
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