Master Implied Volatility Options Strategy In 5 Easy Steps

Can you profit from market uncertainty?

The implied volatility options strategy is the answer.

Implied volatility (IV) is one of the most crucial metrics for traders, because this number can shift rapidly, affecting option premiums dramatically in either direction. Trading strategies based on implied volatility can range from basic to intricate, with various approaches and sometimes puzzling terminology. (Vega neutral options trading strategy, anyone?)

No matter their sophistication, all volatility trading strategies are built upon two fundamental concepts: historical and implied volatility.

Below are five proven steps for trading implied volatility, and when an investor might deploy them in their trading arsenal. While these options trading tips are relatively straightforward, they can provide significant trading advantages — though they carry notable risks.

Here are some key insights about options volatility analysis and term structure before we begin. 

Understanding Implied Volatility in Options Trading 

Implied volatility (IV) represents the market’s expectation of how much an underlying asset’s price of a stock will fluctuate going forward.

When determining the premium of an options contract, stock traders consider both the direction of the underlying asset’s price movement as well as the anticipated magnitude of those price changes. This anticipated level of volatility is known as implied volatility.

Unlike historical volatility, which looks at past price swings, implied volatility is forward-looking. It’s derived from the current market price of the option itself, rather than being directly observable. Options pricing models like Black-Scholes can work backwards from the option’s premium to determine the level of volatility the market is implying.

Traders utilize implied volatility in a few crucial ways. First, it helps them gauge whether options are relatively cheap or expensive – options with higher IV will have higher premiums, all else being equal. Second, some traders attempt to profit from changes in IV itself, buying when it’s low and selling when it’s high. 

How Implied Volatility Works With Example

Let’s examine a practical example using Apple Inc. (AAPL) stock. Suppose AAPL’s current market price is $175, and we’re analyzing two distinct expiration dates:

• 30-day expiration: the IV stands at 25.4%, suggesting a potential price movement of approximately $15.20. This translates to a trading range between $159.80 and $190.20 over the next 30 days.
• 180-day expiration: the IV jumps to 32.8%, indicating a larger potential swing of about $45.60. This projects an expanded range between $129.40 and $220.60 over the six-month period.

87% of options traders fail at implied volatility options strategies, but you can be in the top 13%.

Here is how… 

Implied Volatility Options Strategy in 5 Easy Steps

Trading implied volatility (IV) involves options trading strategies that seek to profit from changes in the market’s expectations of future volatility. Here are some common implied volatility trading strategies:

We believe the long strangle options strategy is the best options trading strategy to beat the market makers at their own volatility trading game.

Here’s how…

Developing a Winning Implied Volatility Options Strategy

Trading implied volatility with the long strangle options strategy involves one long call and one long put, with both options having the same underlying stock and expiration date, but different out-of-the-money (OTM) strike prices.

This means the call strike will be higher than the current stock price, and the put strike will be lower. So, why would you do this instead of other volatility trading techniques?

Let’s break down the ins and outs of a long strangle strategy in five easy steps:

Step 1: Identify Market Conditions

A long strangle is typically favored when implied volatility is low which is reflected on the stock price chart by price consolidation and the trader expects a substantial move in the price of the underlying stock (up or down).

In this scenario, the cost of purchasing both the call and put options may be relatively lower, making it more attractive to initiate a strangle options position.

Long strangles are often used before major stock market events like:

• earnings releases,
• merger announcements,
• product launches,
• shareholder vote
• etc.

Example: Let’s suppose you expect Apple’s stock price to make a substantial move of 8-10% in either direction following the earnings report.

Step 2: How to Choose the Right Options with Low Implied Volatility

When a stock trader sets up a long strangle position, they’re essentially creating two separate options positions: a call option above the current price and a put option below it.

To identify the right options with low implied volatility, consider the following factors:

• Expiration date: Choose an expiration date that aligns with your expected timeline for the anticipated price move.
• Strike prices: Select call and put strike prices that are roughly equidistant from the current stock price, with a wider spread between the strikes when implied volatility is lower.

Example:

Looking at the options chain for AAPL, you decide to target the weekly options expiring the Friday after the earnings announcement. You select a call option with a strike price of $180 (slightly out-of-the-money) and a put option with a strike price of $170 (also slightly out-of-the-money).

The call option is currently trading at $3.50, and the put option is trading at $2.80, for a total cost of $6.30 to establish the long strangle position.

Step 3: Calculate Break-Even Points 

To determine the break-even points for your long strangle position, you need to add the total cost of the trade (call premium + put premium) to the lower strike price for the downside break-even, and subtract the total cost of the trade from the higher strike price for the upside break-even.

Here is an example of implied volatility calculation:

Example: 

To calculate the break-even points for this long strangle position, you add the total cost of $6.30 to the lower strike price of $170 for the downside break-even, and subtract the total cost from the higher strike price of $180 for the upside break-even.

Downside break-even: $170 – $6.30 = $163.70 Upside break-even: $180 + $6.30 = $186.30.

Step 4: Monitor Volatility and Price Movements

If the stock price moves significantly in either direction, you may need to adjust your position or consider taking profits. Conversely, if the stock price starts moving towards one of the break-even points, you may need to adjust your position or consider closing it.

Step 5: Execute and Manage the Trade 

When executing a long strangle trade, be mindful of the options’ bid-ask spreads and try to get the best possible execution prices. It’s also important to have a clear exit strategy, such as:

• Closing the position when the stock price moves past one of the break-even points
• Taking partial profits when the position reaches a certain percentage of your target
• Adjusting the position by rolling the options or converting to a different options strategy

Example:

On the day of the earnings release, AAPL stock price gaps up by 9% to $185 per share. Your $180 call option is now worth $5.00, and your $170 put option has expired worthless. You decide to sell the call option, locking in a profit of $1.50 per contract ($5.00 – $3.50 = $1.50).

Key Takeaways

Master implied volatility options strategy in 5 easy steps:

1. Find stocks with low implied volatility but expected 8-10% price swings
2. Buy slightly OTM call and put options
3. Set downside break-even at lower strike minus total premium paid
4. Watch for big moves
5.  Limit position size to 1-2% of account to manage risk