So the markets have been a bit crazy, first plunging and then rallying sharply only to go down again and volatility is up so you probably think that this means more risk in selling premium, well think again. Tom Preston, aka TP, aka Fifty Percent is here to explain it all.
Higher IV means those selling OTM options receive higher credits. Also, the increase in the credit isn’t linear. The larger the increase in vol, the larger the percent increase in the OTM option at the same strike. Additionally, the probability calculation is affected. . The higher the IV, the lower the probability of expiring worthless for a given strike. The practical effect is that when volatility is higher, the strike with a 68% prob of expiring worthless is further OTM.
The formula of the probability of expiring for an out-of-the-money (OTM) call and put were displayed. TP explained the formula and its implications. A graph of two normal distributions of implied volatility (high and low) were displayed. The graph showed that the 1 standard deviation strike was further out in high IV as compared to low IV.
The relationship between volatility, probability and option price is more complex than most assume. Many might assume that if we move the strike further out-of-the-money so the probability of expiring worthless would be the same that the option price would be lower. They should be pleasantly surprised to learn that they are wrong. You collect a greater credit. Our breakeven then is also farther away.
Fifty Percent then provided an example. A table of an underlying trading at $200 and using put options with a probability of being OTM at expiration of 68% and using 45 days to expiration (DTE) was displayed. The table included four different implied volatility levels (15,20,25,30), the theoretical put strike price, put theoretical value, percentage how far the OTM strike was and the percentage increase in the put premium.
Watch this segment of “The Skinny on Options Modeling” with Tom Sosnoff, Tony Battista and TP/Fifty Percent for a better understanding of implied volatility, its relationship to risk and why higher implied volatility does not necessarily mean higher risk. The results will surprise you.