In our first video detailing the tastytrade and dough trading strategy, we discussed selling premium. Selling premium is the core concept of our trading philosophy - it’s our bread and butter.
If you've watched the first video, you know that by selling an option, we are “selling premium.” When we sell an option, we receive a credit which is equal to the price of the option (the premium). The amount of the credit is the most that we can make on the trade - it’s our max profit. Since option prices change based on a number of different variables, paying attention to these variables can help us distinguish between periods when option prices are relatively low and when they are relatively high. One of the most important variables we pay attention to is implied volatility. The third video in this series looks at implied volatility and how we use it in our trading.
First, it’s important to understand that when volatility is high, option prices are more expensive compared to when volatility is low, all else equal. Since we typically sell options, we prefer to sell when volatility is high as this allows us to receive a higher credit for the trade and also improve our probability of profit. We do this because volatility tends to be overstated, meaning stocks usually moves less than what their implied volatility is predicting and therein lies our edge. This provides us with an opportunity to sell options with the expectation that over time, the underlying will stay within our profit range more often than not. In other words, we try to spot certain conditions in the market to take advantage of when options might be relatively overpriced.
So, we like to sell premium when the implied volatility of an underlying is “high” because we can get greater credit for the trade, increase our probability of profit by widening our breakevens, and should the price of the underlying stay within our profit zone, the trade will be successful.
But, how do we know if IV is high?
We need to compare an underlying stock’s current implied volatility to where it has been over a certain period of time. The implied volatility number alone doesn’t do us much good unless we have something to compare it against. To do this we put context around the current level of implied volatility by using a measure we call IV Rank.
IV Rank shows us where the current level of implied volatility is in relation to the range that it’s been in over the previous 52 weeks. For example, if a stock has an IV of 20%, this might seem low at first glance, but if we know that the stock’s IV has been around 10% over the last year, then an IV of 20% is actually high. This would give the underlying an IV Rank of around 100, since it’s at the high end of the range it’s been in over the last year. When this occurs there might be more of an opportunity to sell premium since the option prices will likely be higher than when IV was less than 20%.
By putting context around implied volatility we can better understand if implied volatility is high or low and determine the appropriate strategy to use for a trade.
Like this video? Let us know in the comments below and please check out more videos like it in our quick tips and trading strategies YouTube playlist!