Build the Perfect Option Trade with Implied Volatility
Volatility is by far the most important key to long-term profitability in options trading.
Learn volatility or lose money. The choice is yours. And today, I’m going to tell you everything you need to know to use volatility to your advantage.
See, volatility is exactly what allows you to make your profits asymmetrical – getting out more than you put in. You can keep your risk low, all while ensuring your returns will be high.
But I’m not just referring to the “market volatility” the news anchors gab about. These talking heads are working for the guys on Wall Street, not for you. They aren’t going to tell you about volatility’s true implications – I am.
In reality, volatility is so much more than just the broader market’s movement. It’s also one of the most important parts of an option’s price.
See, options pricing models use five main factors:
The first four are easy to determine. The price of the underlying is simply the share price of the stock. You can count the time to expiration in calendar days. The strike price is the fixed price at which the contract will be exercised, and the carrying cost is the interest, less the dividend, on owning a stock on margin between now and expiration.
Number five is why we’re here today. Forward volatility is how much the stock is expected to move, regardless of direction, between now and expiration.
Now, I don’t know exactly how much a stock is going to move in the future. No one does – not even the so-called Wall Street “experts.” And that virtually unknown piece is the core of what options are about.
While you may not be able to find the forward volatility, you can find something called implied volatility, or IV. That’s the secret weapon Wall Street uses to predict a stock’s future. And it’s what the big guys use to make sure their profits are greater than their risk every single time. IV is exactly how Wall Street makes its returns asymmetrical, maintaining its spot at the top of the financial food chain.
But now, it’s your turn. You can use IV to make your own returns asymmetrical. And together, we can knock Wall Street – and its innate power complex – down to the ground.
All we have to do is take an option’s price and look at the four aspects of it we do know. Then, we can solve for the IV.
That said, it’s important to remember this: Options prices are wrong – a lot. And as a result, so is IV.
But that doesn’t diminish its moneymaking power. It supercharges it.
Implied Volatility in Action: February 2020
Let’s take a look at February 2020 – right before the market fell to its now-infamous COVID-inspired crash.
On Monday, February 3, the S&P 500 was trading at 3,248. At the time, you could buy the March quarterly $3,000 puts, expiring on March 31. Taking the mid-price here, you could have purchased this put for about $24.10.
By expiration, this option was worth a whopping $415.41 – 1,624% higher than on February 3.
Put simply, that $24.10 option price was wrong. And IV is part of what makes up an option’s price, right? So that means the IV was wrong as well.
That’s exactly what allowed buyers of the March 31 $3,000 put option to bank an incredible asymmetrical gain.
Even if you don’t realize it, every time you buy an option, you’re saying, “the implied volatility is too low,” meaning you think IV is going to go up, moving the option price up in response – and handing you a return.
In response, the seller is saying, “no, the IV is too high,” meaning they expect IV to drop, dragging the option price down with it – handing them a return.
Either way, if the IV is wrong, that means it holds moneymaking potential for an option trader. That’s the magic that creates an option trade. But as you can see, it’s not magic at all – it’s based on skills and knowledge. Skills and knowledge that up until now, Wall Street has been hoarding for itself.
Skills and knowledge that I’m unleashing to the individual investor.
IV moves in waves. Sometimes it’s too expensive, sometimes it’s too cheap – but in the end, it tends to “mean revert,” or settle back to an average price. That’s why you make the most money when IV is too high or too low…
Turning Low Volatility into Asymmetrical Returns
When IV is low, that’s when you should buy options. Because no matter if you buy a call or a put, low IV can produce asymmetrical returns and protect you from losses at the same time.
Consider GameStop Corp. (NYSE:GME). On January 21, 2021, the stock closed just over $43.
Suppose you thought that price was too high and assumed that the stock would drop, as many people did. GME was a virtually obsolete company, right? You could have bought the GME February 19 $40 puts for about $7.00.
Well, you already know what happened. The next day, GME shot up over $20 to $65.01 after retail investors used their newfound financial power to drive prices up. Short-selling hedge funds like Melvin Capital got crushed. And you’d likely assume that anyone who bought those $40 puts got hurt as well.
But that’s not what happened.
The $40 puts lost money, sure. But traders weren’t left high and dry. The puts only lost a measly $0.60.
While the stock price jumped more than 50%, the IV on the option went up over 80 points. Because when a stock moves, IV goes up, whether the stock is moving up or down. GME shares may have rallied, but its IV exploded – almost outweighing the movement in the stock, saving put buyers from a money-draining defeat.
And what about call buyers?
Say that instead of purchasing the $40 puts, you’d put your money into the February 19 $60 calls. On January 21, they were worth about $3.40.
We already know the stock shot up 51% to about $65 – clearly increasing the worth of the call option.
But remember, it’s not just about the price of the stock. IV rose as well, and the calls ballooned all the way to about $18.
$3.40 to $18 in one day? That’s the definition of asymmetric returns, turning a small amount of cash into a massive jackpot. It’s a 530% win on a 51% stock move, and it’s the kind of winning trade that used to be reserved for the Wall Street elites.
See, Wall Street used to say that options were too risky for individual traders. But as you can see, just the opposite is true. By purchasing options when IV is low, you can make a killing, and save yourself from any deep losses at the same time.
As if that’s not enough, there’s even more IV can be used for – like predicting a stock’s future.
Just look at this chart of January 2021’s GME short squeeze…
When GME began to fall, the IV, depicted by the red line, also dropped. That was traders saying IV was too high – and so was the stock.
Remember this: IV is smarter than stocks. Before a stock peaks or valleys, IV will start to drop, allowing you to predict a stock’s top or bottom. Just check out the S&P in March 2020:
Yet again, IV was the tell. It started to drop before the market began to rally. On March 16, IV hit a top, with the S&P at 2,360 and IV at 76%.
The market’s bottom was in place just a week later, when the S&P closed at 2,237. Meanwhile, the IV was 20 points lower, at 56%.
That’s exactly how I was able to call the market’s bottom – and how you can do it next time.
You can use IV to predict market tops and bottoms over and over again. In fact, calling the bottom using volatility in the middle of a selloff is exactly what dubbed me as Jim Cramer’s “VIX Guy,” a title I proudly wear today.
That’s the power of implied volatility. But it’s important to remember that while the GME revolution was a great example of the power you can wield over Wall Street, stock moves that big aren’t incredibly common.
But even without triple-digit stock moves, you can still use IV to make asymmetric returns on a daily basis…
How to Use Implied Volatility in Every Trade
It’s clear that options trading is the key to using IV to make asymmetric returns. But how do you know which option to trade? Well, IV can help you determine that too. In fact, it’s the first of four steps…
Now, let’s put it into action.
On February 19, IV on Walgreens Boots Alliance Inc. (Nasdaq:WBA) appeared to be touching a low point:
So I knew I wanted to buy an option.
Then, I looked at the stock’s chart. As it traded at $48.86 with low IV, I determined that the stock was done dropping. So I decided to buy a call.
Looking at the term structure, I could see that the March 19 options had the lowest IV.
Notice the call expiring on March 19 had an IV of 32.93%, while March 12’s was 33.41%, and March 26’s was 33.88%. The choice was obvious.
Next, I looked at the strike prices:
The March 19 $50 calls had an IV of 33.73%, while the $47.50 and $52.50 strikes both had an IV of 34.65%.
So I bought the March 19 $50 calls for $1.30. I was betting that the stock would rise… but it didn’t.
Two weeks later, time had passed, meaning the option’s time value had decreased. In addition, the stock had dropped about $2.00.
Why am I telling you about a losing trade? Well, I’m not. I still managed to pocket a positive asymmetrical return, because the IV saved my bacon.
The 30-day IV went from 33% to 41%, an eight-point gain in volatility. And my options, which would have been worthless, were still worth more than $0.40.
So I didn’t sell my calls just yet. And the next stock move was higher. On March 12, WBA was trading at $53.21. IV was at 54%. And my calls were trading for $3.30.
A combination of increasing volatility, the stock going up, and the power of asymmetric returns made this trade a 150%-plus winner.
In the case of this WBA trade, the stock ended up moving in my favor. But thanks to IV, the stock doesn’t have to go up for your call to be a winner.
Take a look at this pre-earnings play on Apple Inc. (Nasdaq:AAPL)…
On Monday, January 25, AAPL closed at $142.92. The February 19 $145 strike calls, which were out-of-the-money (OTM), cost $6.40 with an IV of 48.17%.
On January 27, AAPL closed down from that price at $142.06, moving the option even further OTM. Typically, the further OTM an option is, the cheaper it is. Yet, take a look at the option’s price…
That’s right – the $145 strike calls went up – all because of the IV.
These calls saw an IV increase of 4.26 points, which ran the value of the calls to $6.60 – up $0.20 while the stock was down almost $1.
The wrong directional choice can still win in an options trade, as long as you’re right on the IV. But if you’re wrong on IV, even the right directional trade can lose.
It’s not black and white, and that’s why Wall Street has kept this information from you. But implied volatility is the single strongest tool to have in your trading arsenal, especially when you’re looking to make asymmetrical returns.
And it’s exactly how I plan to put the financial power into your hands, where it belongs.
With this approach, you can consistently turn Wall Street into the “sucker” – and yourself into the trader with an edge.
To your success,