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 and as well as the implied volatility of the underlying you are trading is key.
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. 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 on a day when volatility is up will enhance the strategies chances of success.
The most frequently utilized long Vega trade is the calendar or time spread. This involves the selling of an option at a strike in the near term expiration and buying of the same strike in a further out expiration. These are commonly done using both weekly and monthly options. The most frequently used short Vega trade is the iron condor. The iron condor involves the selling of a put vertical and call vertical in the same expiration period. There are many different ways to choose the strikes for both of these strategies and that will be the topic of further discussion on this blog from time to time in the future I am sure.
If you are familiar with and comfortable trading these types of trades considering daily and over all implied volatility levels is a must. Using this information effectively should increase your profitability.