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The recent July/August pull back was the largest seen in several years. This pushed Implied Volatility [IV] to levels not seen for several years. It is extremely important for traders to identify when there has been a change in the market’s demeanor. If a shift has occurred, then he or she will need to revisit the strategies they are currently trading to make sure they are still appropriate. Doing this will result in making sure profits are being maximised should the underlying move to the forecast price and also, more importantly, ensure the trades risk is being effectively managed. This article will cover the most effective strategies to trade during a high IV environment as well as the effects high IV has on options.

Table 1, a few paragraphs below, lists the Optionetics strategies that are appropriate to trade when IV is high. It is important to note that when IV is high the market is pricing in a possible large bullish or bearish move in the underlying. Therefore particular care needs to be taken when considering the strategies that make money from a sideways movement (none directional). I encourage you to only consider trades where the breakevens are outside proven support and resistance levels. Also it is imperative that a trading plan is formulated before entering the trade and then adhered to so that a strong breakout run, such as the recent run in gold starting in early September (GLD), doesn’t result in a larger than expected loss being realized. 

Why are the strategies listed in Table 1 appropriate in a high IV environment? Each strategy comprises of buying and selling the same amount of options with the same expiration month. By doing this you are largely hedged against a change in volatility.

I am sure you are all aware that when IV is high options are expensive. This translates to higher bid/ask quotes than if the IV was lower. Any option that is either ATM or OTM at expiration expires worthless. Let’s analyze this scenario a little further. If this IV is high then the current price of the option is higher than in the past. At expiration the option is expected to be OTM and therefore expire worthless. Since the price of the option is high and by expiration it will be worth zero, as each day passes, the option is losing a larger amount than if the IV were at a low or average level. This is why the strategies where time decay is working against you (long call/put, straddle/strangle and ratio backspread) are inappropriate to trade unless IV is low and hence the options are said to be cheap.

Table 1: Appropriate strategies to trade when IV is high.

Figure 1, directly below, illustrates the effect of time decay between the same option with two different IV values.  The red curved line is the option with average IV whilst the orange line is the same option with a 30% higher IV value. On average the higher IV option will lose an extra $3.50 per day. This might not sound like much but with 28 days until expiration this works out to be an additional $98 (28 x 3.5). 

Figure 1 - the impact of high IV on time decay (Theta).

How can a trader tell if IV is low or high? High or low volatility can be easily detected by viewing a 2-year chart of the underlying’s IV. These determinations also help a trader to discern whether the options are relatively cheap or expensive. 

• Cheap options can be defined as "options with a current IV reading in the lower 20% of the previous 2 year range."    
• Expensive options can be defined as "options with a current IV reading that is not in the lower 20% of the previous 2-year range." Keep in mind that if options are not cheap, traders consider them to be expensive.

Personally, I lean towards credit spreads for directional trades within high IV environments. The advantages of credit spreads is that that the underlying can move in 2 out of 3 directions and the trade makes money, time decay (Theta positive) is working for you and commissions costs are reduced should the options expire worthless as anticipated. Optionetics recommends placing credit spreads using options with less than 45 days until expiration. If the underlying is range bound then I look to trade an Iron Condor. Essentially this is constructed by joining the bear call spread and bull put credit spreads together.

For any options trader, it is important to understand what the current IV value is compared to where it has been over the past 12-18 months. This will heavily influence the possible strategies you can consider to take advantage of any expected move. To trade a bullish strategy when there is a bearish setup makes as much sense as trading a low IV strategy when IV is high. The underlying may move in the desired direction however a loss may still be incurred due to a change in the IV. With each and every trade you analyse, make sure you know what the IV is doing.

Make it happen!

Guy Halpin
Senior Writer
Optionetics.com ~ Your Options Education Site

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