Volatility is my bread and butter …
And it’s not just because I was in the room when the VIX was born!
It’s crucial for anyone serious about trading options to get comfortable with the concept of vol …
When you know how vol works, not only will you have a better understanding of risk and the market at large, but you’ll also be able to use volatility to determine the best options to buy.
(Want to know another key way to become a better trader? I’ll tell you the difference between you and the “pros” during my special live event on Thursday at 7 p.m. ET — register here!)
Here’s a volatility pricing primer to get you started.
Let’s Get Volatile
First, let’s clarify the difference between implied volatility (IV) and realized (or historic) volatility.
While realized volatility (or historic volatility) is movement that has already happened, implied volatility is movement that traders are anticipating.
Implied volatility is part of the options pricing model, and the higher the expectation of movement is, the more expensive options get.
Which makes sense, really.
After all, if an option is currently far out-of-the-money (OTM) and traders are expecting little-to-no-movement out of the underlying, selling you a far OTM option isn’t a huge risk, as it looks relatively unlikely the option will finish in-the-money (ITM).
However, if you are buying a far OTM option, and there’s a significant risk the underlying will move, it is more likely your OTM option will finish ITM, representing a greater risk to the option seller.
Furthermore, there is a higher demand for options when it seems likely the underlying will move, because traders use options to hedge.
(This is the philosophy that underlies the VIX, which is a measure of the implied volatility of S&P 500 (Ticker: SPX) options. When traders are concerned the market may make an outsized move, they are more likely to hedge with options, driving up demand and prices of SPX options, and as a result, driving up the VIX.)
Obviously, when you are buying options, you do not want to overpay for your trades.
So ideally, you want to find the most fairly priced (or unfairly priced, in your favor) option to help you capture full profit potential.
Or, on the flip side, if you find a trade you really like, but you see that the options are currently pricing in an outsized amount of volatility, you need to factor that into your trading strategy – and maybe skip the trade altogether, rather than overpay.
The Price Is Right
So how do you find which options are priced in your favor, versus which are charging a premium for IV?
One of the most useful tools you can use is comparing aggregate volatility (normalized implied volatility) for each term structure. This essentially tells you the average volatility of all of the options in that expiration term.
Aggregate volatility is listed directly under the term, with the change in aggregate vol underneath.
When you’re able to look and compare each term head-on, you can see which contracts make the most sense to buy (those with lower aggregate vol) and which make sense to sell (those with higher aggregate vol).
If you’re looking for optimal options pricing, picking a term that has outsized implied volatility priced in puts you at a disadvantage from the get-go – you want pricing to work for you, not against you.
Let’s say I want to trade Ford (Ticker: F).
Looking at the aggregate volatility, the Nov19 contract seems to currently be pricing in outsized vol (39.64%) compared to the Oct22 contract that’s pricing in 37.18%, and Dec17 at 39.01%. If I were looking to purchase an option, the Oct.22 contract seems to be pricing in slightly lower levels of volatility compared to the other terms on the board, and is therefore likely more fairly priced. The January 2022 volatility is also lower than surrounding terms, representing another potential buying opportunity.
On the flip side, selling the Nov. 19 contract might bring in extra premium (and profit) to pad my bottom line.
(When looking at terms, it’s also important to pay attention to scheduled events that could impact implied volatility – such as an earnings report or product release, or even a broader market catalyst like a Fed meeting.)
Skew Your Opinion
Once you’ve determined if the term you’re looking at is priced fairly (or unfairly, as long as it is in your favor), another tool you can use to evaluate option pricing is skew.
A skew chart shows you the implied volatility for each option within a single expiration term. The “X” axis shows the strike price, while the Y axis shows IV.
If you plot each option according to strike-price and IV, the result will be a skew curve:
This is the skew curve for Apple (Ticker: AAPL) September 17 expiration options.
On the left side, you’ll see the implied volatility for out-of-the-money (OTM) puts; the right shows the IV of OTM calls. In the middle, of course, you have at-the-money options.
Generally, you’ll notice the skew of the put-side tends to be steeper, and this is because out-of-the-money puts tend to be in higher demand, have higher IV priced in, and are also typically relatively more expensive.
Imagine skew as a chain. Each link of the chain is connected to the rest, but it is possible to shift the individual links without much disturbance to the chain as a whole.
It is these very “shifted” links that we want to keep an eye out for, as they can represent excellent buying or selling opportunities.
An option that is out of skew shows an aberration in pricing. It is these options where we can give ourselves edge in our trade.
This can be especially true if you are trading a spread – using skew to find options that have an excessive (or not enough) volatility pricing in represents excellent selling (or buying) opportunities relative to other options in that same term.
Let’s take a look at an example.
Looking at term structure, we can see that the aggregate volatility of PayPal (Ticker: PYPL) Oct. 22 expiration options seem favorably priced compared to nearby terms.
Now let’s drill down, and take a closer look at the options within that term, as plotted on a skew chart.
You can see that the OTM 235-strike put option here is out-of-skew – it is pricing in relatively higher volatility than the rest of the put options around it.
This would make that a good option to consider selling, but not a great ‘buy’ opportunity.
Of course, just because an option is priced favorably doesn’t make it a good trade – I certainly wouldn’t skim skew charts as my sole way of determining what I’m going to buy.
But it is a good place to start – or end – as you search for the best option to trade.
Your Only Option,