Understanding Overstated Implied Volatility

Updated: Sep 21, 2019

The reason why we sell options and capture premium is because of the high likelihood that implied volatility is dramatically overstated compared to what it actually has been over a certain time period. When I started out selling puts and covered calls, I had the feeling novice investors should go with aggressive stocks to lock in sufficient premium in order to offset potentially steep losses. But I was wrong and by writing this article, that's something I'd like to change the whole industry about. Never chase high absolute premium but look at the four following major elements to get a thorough understanding of how risky your underlyings are and whether you get paid for the risk you take on.

* IV rank (measuring current IV against a stock's historical IV range)

* Beta

* Largest drawdown compared to the overall market

* Realized standard deviation

Let's dig deeper into one of the most volatile stocks out there: Micron (ticker: MU).

Year-to-date, shares of the technology company are up a stunning 42.7%, easily surpassing the S&P's 16.1%. Now, in terms of risk/reward and standard deviation, Micron doesn't provide investors with an appealing Sharpe or Sortino Ratio as much of its outperformance comes with tonnes of additional volatility. Its maximum drawdown has been 22.5% so far. Also, shares are highly correlated with the US market.

(Source: portfoliovisualiser)

As long as high implied volatility is priced into options, there's nothing wrong with selecting volatile stocks to build your options portfolio. At least, at first glance...

(Source: marketchameleon)

MU's lowest IV has been 35% year-to-date, while its highest has stood at 58%. The middle of that range and thus the IVR of 50% which is a good proxy for option sellers looking for volatility contraction is 46.5%. On average, MU's realized standard deviation is now 48%, indicating there are few moments when you get implied volatility higher than what is very likely going to be the realized one. So, besides facing huge swings in implied volatility and a very wild price action, one doesn't actually benefit from overstated volatility in this kind of stocks. And since I'd like to sell strangles to lower my directional bias, MU doesn't prove to be a good stock with swings in volatility (which introduces Vega risk and thus affects my margin requirement) and sometimes one could sell too cheap options.

Let's take a look at some names, I like a lot more...

(Source: portfoliovisualiser)

A beta of just 0.26 and a remarkably higher Sharpe Ratio and thus better risk/reward profile. Standard deviation amounts to 10.4% over the past 21 months and just 6.84% over the past 9 months. What company does provide this optimal picture? Drumroll... Next Era Energy (ticker: NEE)! Since the beginning of 2018 until now, the largest drawdown was 4.34%. As strangle sellers, that's great as we don't have to adjust our calls all the time. But what about NEE's implied volatility used for options pricing? Believe it or not: an average IV of 15% so far this year, while the actual number stands at 6.84%. What a discrepancy, and things become even better if you recall that shares didn't suffer during December of 2018 but priced in an average IV of 21% equal to the S&P's. However, the S&P-500 did suffer not only a significant drawdown but saw realized volatility spike to 26% in December of last year.

(Source: marketchameleon)

As of today, an average IV of 15% has drastically overstated NEE's realized volatility of 6.8%, but I have to admit that one cannot play out huge contractions in volatility with boring stocks as opposed to aggressive stocks. Though, the flip side of the coin is that one has to time trades in aggressive stocks and there are basically times when IVR is just way too low to get rid of some volatility risk. Stated differently, less volatility in implied volatility can be observed in less volatile securities, while aggressive stocks tend to look way more attractive from an absolute premium standpoint.

A short strangle (I target an initial delta of 10-15) I currently have on is 210/230 expiring on October 18, 2019. I've recently rolled up my 200 puts to 210 to collect more credit.

And if a December 2018 scenario once again occurs, you can widen your strangles even more! That's stuff that will be discussed in other venues.

The last name I want to bring to your attention is CCI, Crown Castle, a cell tower infrastructure REIT. Since October 2018, the S&P-500 has posted a standard deviation of 19.5%, while CCI enjoyed much lower volatility of 16.0%. That does make a lot of sense to me as conservative option seller as shares were able to outperform the broader market while significantly reducing the maximum drawdown. With a market correlation of 0.41, this stock has been a perfect for my short strangle portfolio.

(Source: portfoliovisualiser)

Year-to-date, realized standard deviation is 13.9% while CCI is negatively correlated with the market. Nevertheless, returns have been rock-solid so far with shares being up 36% at the end of August.

(Source: portfoliovisualiser)

Contrary to my belief, the average implied volatility used for options pricing shows a completely different picture: an average implied volatility of 18% and now 22.5%. Great for option sellers as the actual volatility should come in at around 15%. Selling over expensive 'junk' is precisely what I love about options. Don't chase the high yields, focus on solid companies with low beta and overstated volatility that offer multiple opportunities instead.

(Source: marketchameleon)

Just to give you an idea of how volatility affects options pricing, consider the following example.

* Underlying: CCI

* IV: 22.9%

* 30 days to expiration

* Current price: $142.49

* Call strike price: $150

--> Call price: $1.24

If we compare that figure when doing the math with 15% IV, the call value will depreciate to just 32 cents or a 92 cents difference. It's even more impressive if you annualize that difference: 1104 dollars per contract because of the difference between realized volatility and what the market 'fears' it's going to be. Less volatility in CCI's share price, less steep corrections but clearly overstated volatility are the elements I'm looking for as a conservative option sellers.

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