Implied volatility has been predominantly low up until this recent sell-off in the market toward the end of September. With this sudden drop, IV levels and option prices have surged higher to levels not seen since late May This increase gives an edge to option sellers, and the potential decrease, can help them as well. Let’s take a look.
Implied volatility (IV) is the estimated future volatility of a stock’s price. More often than not, IV levels increase during a bearish market and decrease during a bullish market. IV increases push option prices higher and vice versa. The reason is that a bearish market is perceived as riskier than a bullish market. With the possibility of the market continuing to fall, there is a chance IV levels may rise even more. A general trading principle is high IV is a signal to sell credit spreads and low IV is a signal to buy debit spreads.
Selling bull put spreads (and bear calls) during a period of high IV can be a wise strategy. Options are more “expensive” and an option trader will receive a higher premium than if he or she sold the bull put spread during a time of low or average IV. Plus, the higher the credit, the lower the risk. In addition, if the IV decreases over the life of the spread, the spread’s premium will also decrease based on the vega of the spread. Vega measures the option’s sensitivity to changes in the volatility of the underlying asset.
Take a look at this recent chart of the Boeing Co. (BA).
As you can see, the stock has come down to a major potential support level around the $195 area, and it has previously reversed and moved higher when it reaches that level. Provided the market does not tank, an option trader can consider selling a bull put spread right around that level. IV levels are currently elevated as seen below on the six-month IV chart with the red line being the current IV level and the blue line being historical volatility (HV).
If the 190/195 bull put spread was chosen (selling the 195 put and buying the 190 put), a credit of 1.27 (1.98 – 0.71) would be realized. That represents the max profit if the options expire worthless at expiration. But the position also has a negative vega of 0.02 (0.07 – 0.05) as seen below.
If the stock does rise, IV may drop as it tends to do when the underlying rises. If both IVs drop equally 5%, 0.10 would be subtracted from the premium. An option trader could make money from vega, theta (time passing) and delta (positive for this position).
When examining possible option plays, if IV levels are at a level higher than normal traders may be drawn to credit spreads like the bull put spread. The advantage of a correctly implemented bull put spread is it can profit from either a neutral or bullish move in the stock and can profit in three ways: delta, theta and vega.
Senior Options Instructor