Implied volatility (IV) is something discussed multiple times throughout the day on tastytrade. IV is what determines our strike selection when selling premium. It determines our profit potential. It also determines our probability of being profitable.
When price moves higher, volatility decreases. When prices fall, volatility increases. This is often described in terms of fear. When prices are falling investors make less rational decisions with respect to how much they will pay for the protection options can offer. One investor’s irrationality is another trader’s paycheck.
tastytraders know fear is an overpriced commodity. We understand excess premium priced in options will not last. Volatility is mean reverting. When volatility is high, at some point it will drop. When it does, excess premium in options erodes. That is why we want to sell premium when IV is high.
Increased premium baked into the price of an option during times of high IV also allows us to sell options further out of the money than we might otherwise be able. Selling options further away from an underyling’s current price lowers our risk and increases our probability of being profitable.
Moving strike prices we sell further out of the money provides more breathing room for price to move. Increasing that breathing room means an increased probability of being profitable. It also means our risk is lowered. When volatility contracts, those short strikes become even further out of the money.
Another benefit of high IV is size reduction. Because premium is more expensive when IV is high, we can reduce the number of contracts sold while still collecting the same amount in premium. That affords us the ability to spread our trades out over more underlyings.
Successful traders understand consistent money is made selling premium. Trading direction may be fun, but it’s a 50/50 shot. We have the mathematical evidence proving volatility contracts. No such proof exists for directional trading. Yes, we take our directional shots because we are human. But high IV is where our bread is buttered.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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