Why The Implied Volatility Rank Is Critical To Successful Option Selling

What's the merit of selling options? Everyone would immediately be screaming: income! But what makes selling options so lucrative compared to more traditional investments? Various factors that have a major impact on our option selling success stories - other than smart strike price selection, market assessment, position management - include the IV rank (Implied Volatility Rank). This element exerts a massive influence on how we can trade profitably. For example, if XYZ has had an IV between 30 and 60 over the past year and IV is currently at 45, XYZ would have an IV rank of 50%. Since all securities have unique IV ranges, stating an arbitrary IV number does not help us decide how we should proceed with a strategy.

Put simply, the IV Rank is used to determine when option pricing is relatively pricey or cheap compared to its historical implied volatility for a specific security. If the IV rank is higher than 50% with no upcoming earnings report during the current options cycle, it indicates the chances of a potential implosion in volatility is likely and that is exactly what we as option sellers want to achieve: fast deterioration in value of the options we sold. In other words, selling options which factor in high volatility (way too much in our opinion, because we want to sell overvalued options) is lucrative as one expects volatility to revert to its mean.

As always, when we sell options we want to trade in high-probability manner without betting on the direction of the stock. Knowing when options are very likely overvalued will turn the odds even further into our favor. Let me give you a real-life example and trade I executed when markets were dragged down by trade war tensions (and because of China devaluing its currency). As you can see from the screenshot right below, the IV rank spiked to a humongous 93%... with no upcoming events related to the company. With an implied volatility of 51.2% versus an average realized historical volatility of 42% there's a huge discrepancy between what the market predicts and what the actual volatility is likely going to be. That day I sold several ATM puts to benefit from a huge drop in volatility and a potential recovery in share price.

As can be noticed on the chart below, there will be always turbulent times but as option sellers we then lock in a very high premium even for deep out-of-the-money puts. Option buyers, conversely, have to figure out into which direction the stock will move and whether volatility is going to pick up since Vega, one of the option Greeks measuring the impact of changing volatility on the option prices, is very important to consider. Option buyers want to see prices go up and with time ticking away, it's often very difficult to handle decreasing volatility without a very strong directional move in the share price.

So, in addition to simply looking for the best stocks with the best technicals and fundamentals, we should take into account that implied volatility rank will dictate how fast we can close out our trade. Because let's say you sold options on a stock with a rather low IV rank. You will not only capture less premiums, but you also face potentially rising volatility through the options cycle, making it tougher to exit a position (because volatility determines a strike's delta and thus the time value component attached to it).

72 views2 comments

Option Generator

Company number: BE 0750.963.805

©2021 by Option Generator - All rights reserved