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July 8, 2015

It Could be a Double Play

With Alcoa announcing its earnings this past week and a plethora more of them to soon follow, it might be a good time to talk about a subject that is brought up quite often in MTM Group Coaching and Online Education; double calendars vs. double diagonals.

Double Calendars vs. Double Diagonals
Both double calendars and double diagonals have the same fundamental structure; each is short option contracts in nearby expirations and long option contracts in farther out expirations in equal numbers. As implied by the name, this complex spread is comprised of two different spreads. These time spreads (aka known as horizontal spreads and calendar spreads) occur at two different strike prices. Each of the two individual spreads, in both the double calendar and the double diagonal, is constructed entirely of puts or calls. But the either position can be constructed of puts, calls, or both puts and calls. The structure for each of both double calendars or double diagonals thus consists of four different, two long and two short, options. These spreads are commonly traded as “long double calendars” and “long double diagonals” in which the long-term options in the spread (those with greater value) are purchased, and the short-term ones are sold. The profit engine that drives both the long double calendar and the long double diagonal is the differential decay of extrinsic (time) premium between shorter dated and longer dated options. The main difference between double calendars and double diagonals is the placement of the long strikes. In the case of double calendars, the strikes of the short and long contracts are identical. In a double diagonal, the strikes of the long contracts are placed farther out-of-the-money) OTM than the short strikes.

Why should an option trader complicate his or her life with these two similar structures? The reason traders implement double calendars and double diagonals is the position response to changes in IV; in other words, the vega of the position. Both trades are vega positive, theta positive, and delta neutral—presuming the price of the underlying lies between the two middle strike prices—over the range of profitability. However, the double calendar positions, because of the placement of the long strikes being closer to ATM, responds favorably more rapidly to increases in IV while the double diagonal responds more slowly. Conversely, decreases in IV of the long positions has a negative impact on double calendars more strongly than it does on double diagonals.

If you have only traded a single-legged calendar or diagonal through earnings season even not during earnings season, it might just be time to give them a look. Maybe you have never traded a calendar or a diagonal. This might be the time to find out about these time spreads.  Once a single position spread makes sense, a double might make even more sense and be more profitable too.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 9, 2015

Debit Spread versus Credit Spread

Students in my Group Coaching class as well as my one-on-one students ask me all the time how do you decide between buying a debit spread and selling a credit spread? This is inherently a discussion that could fill a thick book so I will just try to give you a few thoughts to consider.

Risk and Reward

A debit spread such as a bull call spread or a bear put spread is considered to have a better risk/reward ratio then a credit spread such as a bull put spread or a bear call spread. Usually the reason is because the debit spread is implemented close to where the stock is currently trading with an expected move higher or lower. A credit spread is many times initiated out-of-the-money (OTM) in anticipation the spread will expire worthless or close to worthless. For example, if a stock is trading at $50 and an option trader expects the stock to move about $5 higher the trader could buy a 50 call and sell a 55 call. If the 50 call cost the trader $5 and $3 was received for selling the 55 call, the bull call (debit) spread would cost the trader $2 (also the maximum loss) and have a maximum profit of $3 (5 (strike difference) – 2 (cost)) if the stock was trading at or above $55 at expiration. Thus the risk/reward ratio would be 1/1.5.

If the option trader was unsure if the $50 stock was going to move higher but felt the stock would at least stay above a support area around $45 the trader could sell a 45 put and buy a 40 put. If a credit of $1 was received for selling the 45 put and it cost the trader $0.50 to buy the 40 put, a net credit would be received of $0.50 for selling the bull put (credit) spread. The maximum gain for the spread is $0.50 if the stock is trading at $45 or higher at expiration and the maximum loss is $4.50 (5 (strike difference) – 0.50 (premium received)) if the stock is trading at or below $40 at expiration. Thus the risk reward ratio would be 9/1.

Probability

The risk/reward ratio on the credit spread does not sound like something an option trader would strive for does it? Think of it this way though, the probability of the credit spread profiting are substantially better than the debit spread. The debit spread most certainly needs the stock to move higher at some point to profit. If the stock stays at $50 or moves lower, the calls will expire worthless and a loss is incurred from the initial debit ($2). With the credit spread, the stock can effectively do three things and it would still be able to profit. The stock can move above $50, trade sideways and even drop to $45 at expiration and the credit spread would expire worthless and the trader would keep the initial premium received ($0.50). I like to say OTM credit spreads have three out of four ways of making money and debit spreads usually have one way depending on how the spread is initiated.

Implied Volatility

Another thing to consider when considering either a debit or credit spread is the implied volatility of the options. In general, when implied volatility is low, options are “cheap” which may be advantageous for buying options including debit spreads. When options are “expensive”, it may be advantageous to sell options including credit spreads. Option traders that are considering selling a credit spread should also take into account if the implied volatility is perceived as being high. Just the opposite, option traders that are considering buying a debit spread prefer the implied volatility to be low. As a general rule of thumb, I look at the 30-day IV over the last year and make note of the 52-week high and 52-week low. If the current 30-day IV is below 50% (closer to the 52-week low), I look at it is more of an advantage to do a debit spread over a credit spread. If the current 30-day IV is above 50% and closer to the 52-week high, I look at it as an advantage to implement a credit spread over a debit spread. I will not change my outlook like switching to a debit spread from a credit spread because the IV is relatively low. If this is the case, an option trader should maybe consider looking somewhere else for profit.

There are several factors to consider when choosing between a debit spread and a credit spread. The risk/reward of the spread, the probability of the trade profiting, the implied volatility of the options and the outlook for the underlying are just a few to consider. A trader always wants to put the odds on his or her side to increase the chances if extracting money from the market.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 7, 2015

Historical and Implied Volatility

With the market supposedly heading towards the slower summer months, it is always important but probably even more so for option traders to understand one of the most important steps when learning to trade options; analyzing implied volatility and historical volatility. This is the way option traders can gain edge in their trades especially when the volatility of the underlying may be reduced. But analyzing implied volatility and historical volatility is often an overlooked process making some trades losers from the start.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 20 historical volatility is less volatile than a stock with a 25 historical volatility. Additionally, a stock with a historical volatility of 35 now is more volatile than it was when its historical volatility was, say, 20.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks forward. Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options. For example, the market (collectively) expects a stock that has a 20 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile.

Analyzing Volatility
Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are misinterpreted by new or less experienced option traders.

Volatility chart practitioners need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted.

But that is not where the story ends. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sale; if it is below its normal level it may be a good buy.

Finally, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity known as the skew by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is different. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade which is precisely what every trader needs!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 30, 2015

Risk/Reward is Ever Changing in AAPL

There are quite a few option strategies have defined maximum rewards that are approached as a result of the passage of time, changes in implied volatility (IV), and/or movement or lack of movement in price of the stock. Examples of such strategies include the sale of naked options and vertical spreads.

As the positions “mature” or moves closer to expiration by virtue of various combinations of changes or lack of change in these three main variables, the initial risk/reward calculation often changes and sometimes even dramatically. The successful options trader with a proper options education is aware of these changes, because the risk to gain the last bit of potential profit is often dramatically out of whack to the magnitude of the profit he or she seeks to obtain. Let us consider the hypothetical example of a trader who has elected to open a position as a naked put seller. This trader has chosen to sell out-of-the-money (OTM) puts, the June 120 strike, on AAPL which currently trades at $130 after earnings in this example. His risk in the trade is that he is obligated to buy AAPL at the strike price at any time between opening the trade and June expiration. For taking the risk of writing these puts, his account receives a credit of $0.40 and margin is encumbered based on SEC rules. The credit received when the trade is opened is the maximum amount of money that can or will be received as a result of the trade.

As June expiration approaches, the stock remains around the $130 level and the market price of the puts he has sold decreases as a result of time (theta) decay. As the price of the puts decreases and the profits increase, the risk/reward increases. As the price declines below the often used 20% re-evaluation benchmark (although I like to use 50% as well) of the initial credit received, the risk incurred to gain the remaining residual premium is potentially substantial and may no longer be appropriate given the reward.

The experienced options trader will many times take profits and find opportunities to invest his or her money in other trades that appear to be much more attractive from a risk/reward standpoint than to remain in the existing position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 23, 2015

Determining Option Strategies on NFLX

Compared to trading equities, there are so many more option strategies available to an option trader. But more importantly: Do you know why there are so many different types of options strategies? This is the real root of our discussion and why getting a proper options education can help a trader better understand all of those strategies and when and how to use them.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish NFLX traders. Now that the stock has recently gapped up big after earnings and has broken through several resistance areas and is now trading around its all-time high, there are traders who continue to be extremely bullish on the stock. Some option traders want to get more bang for their buck and buy short-term out-of-the-money calls. This might not be the most prudent way to capture profits but that is a discussion for another time. Less bullish traders might buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high (which it currently is not but it has been rising) and the trader is bullish just to a point, the trader might sell a bull put spread (credit spread), and so on.

The differences in options strategies, no matter how apparently minor, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each difference. Traders need to consider the following criteria:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

Carefully defining your outlook and intentions and selecting the best options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. With summer coming soon and supposedly the slow markets, now is a great time to spend optimizing your options strategies over the next few weeks to build the habit!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 15, 2015

Fractal Position Management

Option traders have to manage risk. Want a job description? That’s about it. In fact that is a job description for every trader; even ones that don’t trade options. Every trade has a risk and reward associated with it and traders must realize that especially when first learning how to trade. Because options are instruments of leverage, it is very easy to let risk get out of control, if you’re not careful. Traders must manage risk carefully, instituting tight leashes on their options, spreads and portfolio. The management technique of each is essentially the same because position management is fractal.

Something that is fractal has a recurring pattern that has continuity within its scale. For example, a tree is fractal. A tree has a trunk with limbs extending from it; limbs with smaller branches extending from it; smaller branches with yet smaller branches; and leaves with veins that branch off within each leaf. The pattern is repetitive within each iteratively smaller extension of the last. This is found in option position management too.

Individual options have risk that must be managed. They have direction, time and volatility risk which are managed by setting thresholds for each of the corresponding “greeks” which measure them. When individual options are a part of a spread, the resulting spread has these same risks of direction time and volatility. The spread’s risk must consequently be managed likewise. A trader’s complete option portfolio, which may be comprised of many spreads has systematic risk in accordance to the market. These risks are the same as for individual options or individual spreads: direction, time and volatility. Traders should treat their all encompassing portfolio as a single spread and use the portfolio “greeks” to set parameters to minimize the total risk of the portfolio.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

April 2, 2015

Options and Earnings Season

With Alcoa expected to announce their earnings this coming week and a plethora of companies shortly afterwards, it is probably a good time to review how an option price can be influenced.

Perhaps the most easily understood of the option price influences is the price of the underlying. All stock traders are familiar with the impact of the underlying stock price alone on their trades. The technical and fundamental analyses of the underlying stock price action are well beyond the scope of this discussion, but it is sufficient to say it is one of the three pricing factors and probably the most familiar to traders learning to trade.

The option price influence of time is easily understood in part because it is the only one of the forces restricted to unidirectional movement. The main reason that time impacts option positions significantly is a result of the existence of time (extrinsic) premium. Depending on the risk profile of the option strategy established, the passage of time can impact the trade either negatively or positively.

The third option price influence in relation to earnings season is perhaps the most important. It is without question the most neglected and overlooked component; implied volatility. Because we will be in the midst of earnings season soon, it can become even a greater influence over the price of options than usual. Implied volatility taken together with time defines the magnitude of the extrinsic option premium.

The value of implied volatility is generally inversely correlated to the price of the underlying and represents the aggregate trader’s view of the future volatility of the underlying. Because implied volatility responds to the subjective view of future volatility, values can ebb and flow as a result of upcoming events expected to impact price like a quarterly earnings announcement. In addition, FDA decisions, potential takeovers and sometimes product announcements can also effect the implied volatility and option prices just to name a few more.

New traders beginning to become familiar with the world of options trading should spend a fair amount of time learning the impact of each of these option price influences. The options markets can be ruthlessly unforgiving to those who choose to ignore them especially over earnings season.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 12, 2015

Implied Volatility and Bull Put Spreads

Implied volatility (IV) has been relatively low in the market until recently. With recent downturn in the market, some implied volatility levels have increased of of their recent lows. Implied volatility by definition is the estimated future volatility of a stock’s price. More often than not, IV increases during a bearish market (or a sell off like we have been seeing) and decreases during a bullish market. The reasoning behind this comes from the belief that a bearish market is more risky than a bullish market. The jury is still out on whether this current bullish market can continue through the summer but regardless, now may be a good time to review a strategy that can take advantage of higher implied volatility even if it doesn’t happen this week. Option traders need to be prepared for all types of trading environments.

Reasoning and Dimensions

Selling bull put spreads during a period of high implied volatility can be a wise strategy, as 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 implied volatility. In addition, if the implied volatility decreases over the life of the spread, the spread’s premium will also decrease based on the option vega of the spread. Option vega measures the option’s sensitivity to changes in the volatility of the underlying asset. The implied volatility may decrease if the market or the underlying moves higher.

Outlook and the VIX

Let’s take a look at an example of selling a bull put spread during a time of high implied volatility. In this recent environment, the CBOE Market Volatility Index (VIX) has recently moved from just below 14 percent to about 17 percent in about two weeks which was accompanied by a decline in the market over that same time period. The VIX measures the implied volatility of S&P 500 index options and it typically represents the market’s expectation of stock market volatility. Usually when the VIX rises, so does the implied volatility of options. Despite the drop, let’s say a trader is fairly bullish on XYZ stock. With the option premiums increased because of the implied volatility increasing, a trader decides to sell a bull put spread on XYZ, which is trading around $53 in this example.

Selling the Spread

To sell a bull put spread, the trader might sell one put option contract at the 52.5 strike and buy one at the 50 strike. The short 52.5 put has a price of 1.90, in this example, and the 50 strike is at 0.90. The net premium received is 1.00 (1.90 – 0.90) which is the maximum profit potential. Maximum profit would be achieved if XYZ closed above $52.50 at expiration. The most the trader can lose is 1.50 (2.50 – 1.00) which is the difference between the strike prices minus the credit received. The bull put spread would break even if the stock is at $51.50 ($52.50 – $1.00) at expiration. In other words, XYZ can fall $0.50 and the spread would still be at its maximum profit potential at expiration. If the VIX was still at 12 percent like it had been previously, the implied volatility of these options could be lower and the trader might only be able to sell the spread for 0.90 versus 1.00 when it was at 18%. Subsequently the max loss would be 0.10 higher too. In addition, if the IV decreases before expiration (like it has been known to do if the underlying rises), the spread will also decrease based on the option vega which could decrease the spread’s premium faster than if the IV stayed the same or if it rose.

Final Thoughts

When examining possible option plays and implied volatility is 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 that it can profit from either a neutral or bullish move in the stock and selling premium that is higher than normal.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

February 5, 2015

What is an Option Strangle?

An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

An option strangle has two breakeven points just like the option straddle. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (for upside moves). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on an option strangle is the net premium paid.

Implied Volatility

The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.

Example Trade

To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Apple Inc. (AAPL) looks good for a potential option strangle since at the time of this writing, it is teetering around its all-time high at $120. With IV lower than HV and the trader unsure in what direction the Apple stock may move, the option strangle could be the way to go. The trader would buy both an March 125 call and an March 115 put. For simplicity, we will assign a price of 2.00 for both – resulting in an initial investment of $4 (2 + 2) for our trader (which again is the maximum potential loss).

Apple Stock Rallies

Should the Apple stock rally past the call’s breakeven point which is $129 (125 + 4) at expiration, the 115 put expires worthless and the $125 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $133 which means the intrinsic value of the call $8 (133 – 125), the profit is $4 (8 – 4) which represents the intrinsic value less the premium paid.

Apple Stock Declines

The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if Apple stock is trading below the put’s breakeven point of the trade which is $111 (115 – 4), a profit will be realized. The danger is that Apple stock finishes between $111 and $129 as expiration occurs. In this case, both legs of the position expire worthless and the initial 4, or $400 of actual cash, is lost.

Maximum Loss

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 14, 2015

Implied Volatility May Continue to Swing

The last several months, the market has shown some good movement with some wild swings. The S&P 500 and Dow set their all-time highs once again, and then promptly moved lower. Now we are about to start the next earnings season and the roller-coaster ride may continue. It is important for option traders to understand one of the most important steps when learning to trade options; analyzing implied volatility and historical volatility. This is the way option traders can gain edge in their trades. But analyzing implied volatility and historical volatility is often an overlooked process making some trades losers from the start. An option trader needs to look back at the last couple of months of option trading to see how volatility played a crucial part in option pricing and how it will help them going forward.

Implied Volatility and Historical Volatility
Historical volatility (HV) is the volatility experienced by the underlying stock, stated in terms of annualized standard deviation as a percentage of the stock price. Historical volatility is helpful in comparing the volatility of a stock with another stock or to the stock itself over a period of time. For example, a stock that has a 30 historical volatility is less volatile than a stock with a 35 historical volatility. Additionally, a stock with a historical volatility of 45 now is more volatile than it was when its historical volatility was, say, 30.

In contrast to historical volatility, which looks at actual stock prices in the past, implied volatility (IV) looks forward. Implied volatility is often interpreted as the market’s expectation for the future volatility of a stock. Implied volatility can be derived from the price of an option. Specifically, implied volatility is the expected future volatility of the stock that is implied by the price of the stock’s options. For example, the market (collectively) expects a stock that has a 20 implied volatility to be less volatile than a stock with a 30 implied volatility. The implied volatility of an asset can also be compared with what it was in the past. If a stock has an implied volatility of 40 compared with a 20 implied volatility, say, a month ago, the market now considers the stock to be more volatile. A recent example of the implied volatility increasing was the debt ceiling crisis. There was some concern that the government would not hammer out a compromise and thus default which put fear into the market and increased implied volatility.

Analyzing Volatility
Implied volatility and historical volatility is analyzed by using a volatility chart. A volatility chart tracks the implied volatility and historical volatility over time in graphical form. It is a helpful guide that makes it easy to compare implied volatility and historical volatility. But, often volatility charts are misinterpreted by new or less experienced option traders.

Regular users of volatility charts need to perform three separate analyses. First, they need to compare current implied volatility with current historical volatility. This helps the trader understand how volatility is being priced into options in comparison with the stock’s volatility. If the two are disparate, an opportunity might exist to buy or sell volatility (i.e., options) at a “good” price. In general, if implied volatility is higher than historical volatility it gives some indication that option prices may be high. If implied volatility is below historical volatility, this may mean option prices are discounted. High is giid for selling and low is good for buying option premium.

But that is not where the story ends. Traders must also compare implied volatility now with implied volatility in the past. This helps traders understand whether implied volatility is high or low in relative terms. If implied volatility is higher than typical, it may be expensive, making it a good a sell; if it is below its normal level it may still be a good buy.

Finally, traders need to complete their analysis by comparing historical volatility at this time with what historical volatility was in the recent past. The historical volatility chart can indicate whether current stock volatility is more or less than it typically is. If current historical volatility is higher than it was typically in the past, the stock is now more volatile than normal.

If current implied volatility doesn’t justify the higher-than-normal historical volatility, the trader can capitalize on the disparity known as the skew by buying options priced too cheaply.

Conversely, if historical volatility has fallen below what has been typical in the past, traders need to look at implied volatility to see if an opportunity to sell exists. If implied volatility is high compared with historical volatility, it could be a sell signal.

The Art and Science of Implied Volatility and Historical Volatility
Analyzing implied volatility and historical volatility on volatility charts is both an art and a science. The basics are shown here. But there are lots of ways implied volatility and historical volatility can interact. Each volatility scenario is different like an expected earnings announcement or a general fear of the economy. Understanding both implied volatility and historical volatility combined with a little experience helps traders use volatility to their advantage and gain edge on each trade and that is precisely what every trader needs.

Now you know a little more about how implied volatility can affect options, it is time to put that knowledge to use and get the edge in your trades!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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