Options Theory: When Implied Volatility Spikes
Market movements last week command our attention for today’s commentary. We experienced something we haven’t seen in about six months that brought opportunity in its wake.
Do you know what it was?
A spike in implied volatility. A return of fear. An inflation of option premiums.
And it’s not like this development was a secret. Whether you’re tracking the VIX Index (ticker VIX) or have an implied volatility indicator (IV Rank) on your price charts, you should have seen the Monday-Tuesday spike. The VIX, for example, hopped to 15.42 — its highest reading since August 18th.
As a result, option sellers (traders harnessing covered calls, naked puts, credit spreads, etc.) were dancing in the street. For with every volatility spike comes an increase in payouts. Naked puts that were yielding 6% or 7% returns now produce 10% returns. Instead of selling puts that were one strike OTM you can now sell those that are two or three strikes OTM. Such are the goodies that come with a jump in implied volatility.
If you need a quick primer on the VIX Index I suggest reading The Fear-O-Meter and VIX Tricks.
Of course, adding further appeal was the fact that a price pullback accompanied the VIX spike. Given the meteoric rise greeting stocks in January, low-risk entries were becoming increasingly difficult to come by. Stock charts everywhere were begging for a reset. And last week we finally — finally!– got one. As a result bull retracement patterns littered the landscape making it oh-so-easy to find attractive stocks to sell these now juicy options on. EEM, XOP, XRT, and XME were a few in particular that caught my eye.
While you can’t nail the top in implied volatility every time, it’s not that tough to at least get close. And even if you’re a day or two early, you should still be able to profit if the puts you’re selling are correctly selected. Let me share an example using XME going into Friday’s trading. It was down four of the six trading sessions and had a potential reversal candle on Thursday. At the same time, the implied volatility rank had lifted to 70%, its highest level in ages. Could the pullback continue? Sure. Could implied volatility keep ramping? Sure.
But, the price had already pulled back enough, and implied volatility had already risen sufficiently to begin deploying positions. To combat a premature trigger pull you can always scale-in. Enter some now and some later. If you’re early and XME pulls back another day or two, then simply enter the back half of the trade then at the better price.
Imagine with XME at $37.05 on Thursday you sold the March $34 puts for 45 cents. You could have justified your timing with the reversal candle that formed that day. If the pullback persists and XME falls to $35 then, HOORAY!, you can sell more March $34 puts. But now you’re probably getting 75 cents (or more!). And, you might even shift down a strike and sell the $33 put. If the implied volatility rank continued climbing toward 80% or 90%, well, DOUBLE HOORAY!
As long as XME eventually pops (which it should) and implied volatility eventually drops (which it will), your naked puts will pay out.
Got it?
