With the recent spike in market volatility it has become obvious to all option traders that a fundamental knowledge of implied volatility is mandatory.
For the positive theta trader, implied volatility levels are one of the key elements to consider and watch before and after trade entry.
The profitability of positive theta trades, meaning those where the passage of time and option value time decay are beneficial, is affected by time, price movement and implied volatility of the options that are part of the position.
Timing trade entry to day-to-day movements in implied volatility as well as overall market volatility can enhance trade profitability.
The primary way to watch volatility of the broader market is the VIX.
The VIX reflects the implied volatility of the SPX (S & P 500). Since most of the market is highly correlated to the SPX, the VIX is a useful tool to get an overall market volatility weather report.
Considering VIX levels as well as the implied volatility of the underlying you are trading is key. You can also watch the ETF (electronically traded fund) VXX, which trades like a stock and closely follows the VIX.
The VXX Is My Favorite Way To Trade Volatility
Now that we have talked about what implied volatility to monitor, the question is what to do with the information and what does it mean?
A trader should look to enter positive theta, long Vega (volatility) strategies at a time when the IV of the underlying is over all in mid to lower part of the last 3 to 6 months range.
Additionally, entering a long Vega trade on a day when IV has dropped even further is also helpful. The IV will usually go down a bit on a day when the underlying’s price has risen.
Stock Market Positions
As most of the stock market positions are long (benefit from the market going up) when the market goes up implied volatility normally goes down. And of course the opposite, when the market goes down volatility normally will rise.
Therefore entering short Vega trades at a time when the IV of the underlying is in the upper part of the last 3 to 6 month range, and a day when volatility is up will enhance the strategies chances of success.