Our president visited Ukraine over the long weekend and Russian President, Vladimir Putin is ruffling feather as he talks of suspending his country’s participation in the nuclear arms reduction treaty with the United States.
And, to kickstart the week of earnings, Walmart (WMT) shares took a tumble after its year-ahead outlook was lowered – inflation being a key driver.
So, as geopolitical events generate concerns abroad and while fundamental concerns build at home, the result can be market volatility, which in turn can impact implied volatility (IV).
But if you understand the relationship of market trends and implied volatility, you’ll be surprised how you can add an edge to your trading.
Let me tell you two ways you can profit from the IV as it makes ascends to 2022 peak levels.
Understanding The Implied Volatility (IV) Chart – VIX
To get started I’ll say there’s a difference between historical volatility and implied volatility and both can help or hurt your trading if you’re on the wrong side of it.
Let’s begin with historical volatility, which is simply the amount a stock or a market index fluctuates over time. So, if the S&P 500 (SPX) fluctuates 10% of its value throughout a 12-month period, we would say the historical volatility of the index is 10%.
We’d likely see both bullish and bearish movement over the one-year period as well, which means there are opportunities to trade in either direction.
Whether your trades are bullish or bearish, there’s a way you can gain an edge with your trades if you understand the relationship between the market movement and the impact it can have on implied volatility.
So, let’s next talk about the relationship of market movement and IV, and being on the right side of volatility.
Under ordinary circumstances market trend and IV have an inverse relationship – which means when the market trend is rising, IV is typically falling, and vice versa.
The comparison chart below illustrates the inverse relationship. As the S&P 500 (SPX) rises (solid trend line), the Volatility Index (VIX) falls (candlesticks).
Now that you recognize the inverse relationship between market trend and IV, let’s next talk about being on the right side of IV for gain an edge of enhanced profits.
If you notice near the center of the comparison chart above, as the market has trended higher, the IV levels got lower, which informs us that option premiums are becoming deflated, or “cheap.”
Then, as the market peaks and begins to down trend, notice what happens to IV as the SPX declines. Implied volatility rises, telling us that option premiums are becoming inflated in value, or “expensive.”
So, here’s your edge… something most traders are not aware of…
When you purchase put contracts on stocks and ETF’s that are heading down, you’re not only able to profit from the bearish move, but the trade is enhanced as rising IV “inflates” option premiums.
It’s like getting a bonus on top of a great paycheck.
But there’s another way to profit by trading the right side of implied volatility…
If option buyers benefit from rising IV over the duration of their trade, then option sellers have an advantage when implied volatility is high with the potential to decline.
That’s right, there are times that option buyers have an edge and other times when option sellers have the edge.
So, here’s the way option sellers can take advantage of being on the right side of IV:
When traders sell put options for a credit, they are obligated to buy shares of stock if the stock’s price trades below the selected option strike price at expiration. It’s a way for investors to acquire shares of a stock they may desire to own.
However, the stock is only purchased via the option contract when the stock trades below the strike price at expiration. There are a good number of times that the stock’s price will not end up trading below the selected strike price, however, which means we’d keep the credit received from the sell of the put, but not acquire the shares.
It’s an income strategy that can be utilized 12 months out of the year.
So, I’ve spoken about buying a put contract and then receiving the added benefit of rising IV. With your understanding of how option premiums inflate and deflate, as an option seller, the advantage is yours when you sell options that have higher IV, or inflated premiums.
While buying puts is a bearish strategy, selling puts is bullish, and now that you can determine those times when IV is at high or low levels, you’ve now added an edge to your trading – it’s a matter of being on the right side of implied volatility.
In fact, I’m so confident about the IV edge, I’ve got a challenge coming up to show all my readers first hand how to profit with that edge.
Please join me if you can for my Rocket Wealth Challenge coming up next week.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
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