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February 4, 2016

Stock Repair Strategy Using Options

It has been a rough start for investors in 2016 with stocks dropping even more in than they did in December 2015. Is the market ready to rally soon? Some stock buyers are waiting for some of their losers to make their way higher and some are buying more stock at cheaper prices. But as most experienced investors know, the market can always go lower now or in the future. Here is one option strategy that can make sense in some cases; the stock repair strategy.

Introduction to the Stock Repair Strategy

The stock repair strategy is a strategy involving only calls that can be implemented when an investor thinks a stock will retrace part of a recent drop in share price within a short period of time (usually two to three months).

The stock repair strategy works best after a decline of 20 to 25 percent of the value of an asset. The goal is to “double up” on potential upside gains with little or no cost if the security retraces about half of its loss by the option’s expiration.

Benefits

There are three benefits the stock repair strategy trader hopes to gain. First, little or no additional downside risk is acquired. This is not to say the trader can’t lose money. The original shares are still held. So if the stock continues lower, the trader will increase his loses. This strategy is only practical when traders feel the stock has “bottomed out”.

Second, the projected retracement is around 50 percent of the decline in stock price. A small gain may be marginally helpful. A large increase will help but have limited effect.

Third, the investor is willing to forego further upside appreciation over and above original investment. The goal here is to get back to even and be done with the trade.

Implementing the Stock Repair Strategy

Once a stock in an investor’s portfolio has lost 20 to 25 percent of the original purchase price, and the trader is anticipating a 50 percent retracement, the investor will buy one close-to-the-money call and sells two out-of-the-money calls whose strike price corresponds to the projected price point of the retracement. Both option series are in the same expiration month, which corresponds to the projected time horizon of the expected rally. The “one-by-two” call spread is ideally established “cash-neutral” meaning no debit or credit. (This is not always possible. More on this later). To better understand this strategy, let’s look at an example.

Example

An investor, buys 100 shares of XYZ stock at $80 a share. After a month of falling prices, XYZ trades down to $60 a share. The investor believes the stock will rebound, but not all the way back to his original purchase price of $80. He thinks there is a reasonable chance for the stock to retrace half of its loss (to about $70 a share) over the next two months.

The trader wants to make back his entire loss of $20. Furthermore, he wants to do it without increasing his downside risk by any more than the risk he already has (with the 100 shares already owned). The trader looks at the options with an expiration corresponding to his two-month outlook, in this case the September options.

The trader buys 1 November 60 call at 6 and sells 2 November 70 calls at 3. The spread is established cash-neutral.

Bought 1 Nov 60 call at 6
Sold 2 Nov 70 call at 3 (x2)
-0-

By combining these options with the 100 shares already owned, the trader creates a new position that gives double exposure between $60 and $70 to capture gains faster if his forecast is right. The P&L diagram below shows how the position functions if held until expiration.

If the stock rises to $70 a share, the trader makes $20, which happens to be what he lost when the stock fell from $80 to $60. The trader would be able to regain the entire loss in a retracement of just half of the decline. With the stock above 60 at expiration, the 60-strike call could be exercised to become a long-stock position of 100 shares. That means, the trader would be long 200 shares when the stock is between $60 and $70 at expiration. Above $70, however, the two short 70-strike calls would be assigned, resulting in the 200 shares owned being sold at $70. Therefore, further upside gains are forfeited above and beyond $20.

But what if the trader is wrong? Instead of rising, say the stock continues lower and is trading below $60 a share at expiration. In this event, all the options in the spread expire and the trader is left with the original 100 shares. The further the stock declines, the more the trader can lose. But the option trade won’t contribute to additional losses. Only the original shares are at risk.

Benefits and Limitations of the Stock Repair Strategy

The stock repair strategy is an option strategy that is very specific in what it can (and can’t) accomplish. The investor considering this option strategy must be expecting a partial retracement and be willing to endure more losses if the underlying security continues to decline. Furthermore, the investor must accept limiting profit potential above the short strike if the stock moves higher than expected.

Some stocks that have experienced recent declines may be excellent candidates for the stock repair. For others, the stock repair strategy might not be appropriate. For stocks that look like they are finished or may even head lower, the Stock Repair Strategy can’t help – just take your lumps! But for those that might slowly climb back, just partially, this can be a powerful option strategy to recoup all or some of the losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 21, 2016

Implied Volatility Has Soared

With the market testing lows from back in August and earnings season just starting to get underway, 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

November 19, 2015

Analyzing the Whole Market as Well as Individual Stocks

Making stock option picks with profit potentials, whether the market is up or down, depends on diligent market research and a thorough understanding of stock option fundamentals.

Finding profitable trading opportunities can be tough. But you don’t have to do all the work yourself. Some professional trader services, such as Market Taker’s Live Advantage Group Coaching, make stock option picks that they share with fellow market participants, saving individual traders time and effort.

But whether you do your own research or rely on a seasoned professional for your stock option picks, its essential to understand some basic facts about options trading.

Making stock option picks based on individual stock assessment requires an understanding of specific fundamental parameters. Traders may learn how to read an annual report and 10K stockholders report for income statements, past earnings, sales, assets, new products, and overall industry trends.

Stock option picks based on technical analysis is essential for success and requires the investor to examine the historical price movement and volume in order to determine price patterns and extrapolate future price movements. The single most important technical analysis technique is the simplest: Support and resistance lines. Specifically, horizontal support and resistance lines at the same price level in two or more time frames.

Stock option picks based on broad market analysis examines overall activity based on performance indices. Is the overall market bullish (moving up), bearish (moving down) or neutral (moving sideways)? The broad market will affect individual equities.

Stock option picks based on psychological market indicators attempts to interpret the facts and gauge whether a change from bullish to bearish (or vice versa) is in the wind. Successful options traders are frequently contrarians who buy puts in a bullish market and purchase calls in a bearish market — against convention.

The bottom line is, a lot goes into stock option picks. If you have not done so already, let me help you with analyzing your potential trades. Learn more here.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

October 22, 2015

Earnings and Options

With Apple Inc. (AAPL) expected to announce their earnings this coming week and a plethora of companies afterwards, it is probably a good time to review how an option price can be influenced by earnings. Many option traders view quarterly earnings as a perfect time to trade options and in fact they can be. But there are plenty of considerations to take into account.

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 direct result 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 as well as veteran option traders that are 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. In addition, this applies to all option strategies even those not based on an earnings report. 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

October 1, 2015

How Option Delta and Gamma Influence Each Other

Not sure if you have noticed, but the market has been very volatile lately. Stocks have been moving in sometimes dramatic fashion on a daily basis so it might be wise to review how option prices change when the underlying changes. The option “greeks” help explain how and why option prices move. Option delta and option gamma are especially important because they can determine how movements in the stock can affect an option’s price. Let’s take a brief look at how they can affect each other.

Delta and Gamma

Option delta measures how much the theoretical value of an option will change if the stock moves up or down by $1. For example, if a call option is priced at 3.50 and has an option delta of 0.60 and the stock moves higher by $1, the call option should increase in price to 4.10 (3.50 + 0.60). Long calls have positive deltas meaning that if the stock gains value so does the option value all constants being equal. Long puts have negative deltas meaning that if the stock gains value the options value will decrease all constants being equal.

Option gamma is the rate of change of an option’s delta relative to a change in the stock. In other words, option gamma can determine the degree of delta move. For example, if a call option has an option delta of 0.40 and an option gamma of 0.10 and the stock moves higher by $1, the new delta would be 0.50 (0.40 + 0.10).

Think of it this way. If your option position has a large option gamma, its delta can approach 1.00 quicker than with a smaller gamma. This means it will take a shorter amount of time for the position to move in line with the stock. Stock has a delta of 1.00. Of course there are drawbacks to this as well. Large option gammas can cause the position to lose value quickly as expiration nears because the option delta can approach zero rapidly which in turn can lower the option premium. Generally options with greater deltas are more expensive compared to options with lower deltas.

ATM, ITM and OTM

Option gamma is usually highest for near-term and at-the-money (ATM) strike prices and it usually declines if the strike price moves more in-the-money (ITM) or out-of-the-money (OTM). As the stock moves up or down, option gamma drops in value because option delta may be either approaching 1.00 or zero. Because option gamma is based on how option delta moves, it decreases as option delta approaches its limits of either 1.00 or zero.

An Example

Here is a theoretical example. Assume an option trader owns a 30 strike call when the stock is at $30 and the option has one day left until expiration. In this case the option delta should be close to if not at 0.50. If the stock rises the option will be ITM and if it falls it will be OTM. It really has a 50/50 chance of being ITM or OTM with one day left until expiration.

If the stock moves up to $31 with one day left until expiration and is now ITM, then the option delta might be closer to 0.95 because the option has a very good chance of expiring ITM with only one day left until expiration. This would have made the option gamma for the 30 strike call 0.45.

Option delta not only moves as the stock moves but also for different expirations. Instead of only one day left until expiration let’s pretend there are now 30 days until expiration. This will change the option gamma because there is more uncertainty with more time until expiration on whether the option will expire ITM versus the expiration with only one day left. If the stock rose to $31 with 30 days left until expiration, the option delta might rise to 0.60 meaning the option gamma was 0.10. As discussed before in this blog, sometimes market makers will look at the option delta as the odds of the option expiring in the money. In this case, the option with 30 days left until expiration has a little less of a chance of expiring ITM versus the option with only one day left until expiration because of more time and uncertainty; thus a lower option delta.

Closing Thoughts

Option delta and option gamma are critical for option traders to understand particularly how they can affect each other and the position. A couple of the key components to analyze are if the strike prices are ATM, ITM or OTM and how much time there is left until expiration. An option trader can think of option delta as the rate of speed for the position and option gamma as how quickly it gets there.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring Inc.

September 17, 2015

Chicago Cubs and Exiting Your Positions

Can you believe it? The Chicago Cubs look like they will make the playoffs and have a legitimate chance of winning it all! As a life-long Chicagoan, that does not happen very often. Unfortunately, the Cubs have exited the playoffs way to soon over the past 100 years.

The World Series playoffs are about to begin and it is the most exciting time of the year if you are a fan of baseball. But did you ever stop and think for a minute how these fantastic athletes got to be where they are? It took a lot of dedication, courage and a well thought out plan to make it to their elite level. If that sounds familiar it should because those same attributes are what it takes to learn to trade and become a successful options trader.

Need a Plan

You might be dedicated and have the courage to be an options trader, but do you have a trading plan that you follow? I talk to a lot of option traders and sadly it is true. Option traders spend a lot of time looking for solid trades that they often neglect probably the most important part: the management of the trade. If that is you take a little solace because you are not alone.

A simple way to combat this problem is by having a plan in place before even entering the trade. This is the psychological part of trading. Having a plan in place will remove emotions from getting in the way of decision making and possibly producing unwanted results. Should I stay in the trade or should I exit? Decisions like that should not be made after the trade is executed because many option traders can become too emotional when the trade is in progress especially when they are losing money on the trade. Here are a few things to consider about trade management.

Plan Should Include Determining Exits

It is not a good thing for the Cubs to exit the playoffs too soon but it might be a good idea if you exit your option position too soon. Option traders should think about how they are determining their exits for profit and loss. Don’t forget to consider how the greeks and the implied volatility may be affected if the outlook or environment changes. In a volatile market like this, an options trader may need to make some adjustments especially about taking early profits or exiting for a loss.

I generally determine my exits two ways; a certain percentage or based on the chart. When using a certain percentage, I determine how much percentage-wise I am winning to risk on the trade and what percentage I am looking to take profits. When using the chart, I determine at what levels I will exit my position for a loss if that area is violated and I always look to take some profit off if the stock comes into an area I deem a target area (maybe a support or resistance level).

Option traders should also think about how they will exit if their targets are not met. How will the exit or stop be determined? Once again, don’t forget to use the greeks and implied volatility in your methods because it could make the difference between profiting or losing.

Finally

All trading including option trading can be very difficult at times just like training to be a professional athlete and appear in the World Series. Not having plan in place can make it exponentially more difficult and determining exits is just one part of that plan. It helps to have courage and be dedicated to reaching your goals but a solid trading plan can go a long way towards potential success. Athletes that train without a plan are similar to option traders letting their emotions make decisions for them. Once there is well thought out plan in place and most importantly the plan is followed, an option trader removes unwanted emotions which can hinder his or her chances of being successful. Go Cubs!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 25, 2015

Long Calls and Bull Call Spreads

With Nasdaq trading around all-time closing highs and the S&P 500 currently threatening its all-time highs recently, it probably makes sense to keep at least a moderately bullish bias towards many stocks. The market is due for some type of pullback, but who knows when that will happen. Even if it does pullback sooner than later, there will be another bullish opportunity at some point rest assured. Traders often ask me is there a way that you can take advantage of this bullish investing scenario while limiting risk? Certainly, there are a few option strategies that can accomplish this goal. One that may be a better option compared to the rest is a debit call spread which is sometimes referred to as a bull call spread.

Definition

When implementing a bull call spread, an option trader purchases a call option at one strike and sells the same number of calls on the same stock at a higher strike with the same expiration date. Here is a trade idea we looked at in Group Coaching just a couple of weeks ago. Tesla Motors (TSLA) moved up to a resistance area right around $250, formed a bullish base and then closed above resistance at around $253. With implied volatility (IV) generally being low, which is advantageous for purchasing options as with a bull call spread, and a directional bias, a bull call spread can be considered.

The Math

The trader’s maximum profit in the bull call spread is limited; he can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that at the time one June 255 call was purchased for 8.00 and one June 260 call was sold for 6.00 resulting in a net debit of $2 (8 – 6). The difference in the strike prices is $5 (260 – 255). He would subtract $2 from $5 to end up with a maximum profit of $3 per contract. So if he traded 10 contracts, you could make $3,000 (10 X 300).

Although he limited his upside, the trader also limited the downside to the net debit of $2 per contract. To simply breakeven, the stock would have to trade at $257 (the strike price of the purchased call (255) plus the net debit ($2)) at expiration.

Advantage Versus Purchasing a Call

When trading the long call, a trader’s downside is limited to the net premium paid. If he simply purchased the out-of-the-money June 255 call, he would have paid $8. The potential loss is, therefore, greater when implementing a call-buying strategy. If he had moved to a call with a longer time frame to expiration, he would have even paid more for the option. This would also increase his potential loss per option.

Conclusion

By implementing a bull call spread, traders can hedge their bets; limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no sure-fire ways to make money by using options. However, knowing and understanding the strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 28, 2015

Option Gamma and AAPL

Many option traders will refer to option delta as the most important option greek. It is debatable but in my opinion the next most important greek for me is option gamma. Option gamma is a one of the so-called second-order option greeks. It is, in theory, a derivative of a derivative. Specifically, it is the rate of change of an option’s delta relative to a change in the underlying security.

Using option gamma can quickly become very mathematical and tedious for novice option traders. But, for newbies to option trading, here’s what you need to learn to trade using option gamma:

When you buy options you get positive option gamma. That means your deltas always change in your favor. You get longer deltas as the market rises; and you get short deltas as the market falls. For a simple trade like an AAPL June 131 long call that has an option delta of 0.56 and option gamma of 0.0588 , a trader makes money at an increasing rate as the stock rises and loses money at a decreasing rate as the stock falls. Positive option gamma is a good thing.

When you sell options you get negative option gamma. That means your deltas always change to your detriment. You get shorter deltas as the market rises; and you get longer deltas as the market falls. Here again, for a simple trade like a short call, that means you lose money at an increasing rate as the stock rises and make money at a decreasing rate as the stock falls. Negative option gamma is a bad thing.

Start by understanding option gamma from this simple perspective. Then, later, worry about figuring out the math, even if a calculator is still needed!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

May 14, 2015

Adjustments to Option Positions

Although I personally do not like using the word “adjustments” with options trading (I prefer new outlook), there are many times they need to be done. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader’s thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.

Gamma

Gamma—particularly negative gamma—is the cause of the need for adjusting.

Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot…

Delta definition: Delta is the rate of change on an option’s (or option position’s) price relative to a change in the underlying.

In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Finally

Option traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades. Once an option trader has a good grip on what changes need to be made based on his or her new outlook, potential profit can be an adjustment away!

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

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