Use Implied Volatility to Select the Right Option

by Josip Causic

Any chart of upper studies is two-dimensional showing time on the horizontal axis and the price of the underlying on the vertical axis. Lower studies also have the horizontal time component, but instead of the price action, there could be any other variable plotted on the vertical axis; the most common one for the lower studies being volume.

When it comes to options, I often refer to them as a 3D product because they not only have the two components already mentioned above, but they also have implied volatility (I.V).

Many novice traders approach their option trading unsuccessfully due to their sole focus on a single dimension -- price. With options, the price could move in the anticipated direction and the option premium could lose value due to time (second dimension) decay, due to change in the implied volatility (the third dimension), or due to the combination of both time and implied volatility.

Time Decay

At any given time, a trader should be aware of the fact that options, when purchased, are a decaying asset, and that time is working against the premium buyer. (However, when the premium is sold, then the option trader is a seller, and time decay works in his or her favor.)

Time decay is inevitable regardless of what side of the trade we take. One of the ways to decrease the impact of time decay when buying options is to purchase a further away month, perhaps two or three months out depending on our trading plan.

For a directional swing option trader who intends to hold the position for less than a week, the scenario of purchasing either two or three months out would be correct. For the longer-term trader, LEAPS (long-term equity anticipation securities) are the best choice. LEAPS are American-style options with expiration up to three years in the future.

Implied Volatility

Implied volatility is much more difficult to deal with than time. We as options traders have virtually no control over it. I.V. is manipulated by the market makers.

When I.V. is high, then the premium of the underlying tends to be overpriced, and vice versa. Low I.V. equals undervalued premium.

In this article, I will give an example of an almost ideal situation in which the underlying's I.V. is at its lowest annual levels -- the Financial Select Sector SPDR (XLF).

I am naming the underling for education purposes only, since the process of verifying the facts could easily be done by any reader on any other underlying.

The exact place on the Web site where the information can be found is (Chicago Board Options Exchange).

The fifth tab from the left, Trading Tools, has the Volatility Optimizer selection under which the very first choice should be selected -- the IV Index. It is a free service that is powered by the IVolatilty Web site for which the users are required to have a log in. By using the CBOE Web site, the log-in step is eliminated.

Let's move on to the exact example that I had in mind. As I said, the underlying with the lowest I.V. at the time of this writing was the XLF.

The XLF's I.V. Index mean of both calls and puts have an I.V. in the range of 130% being the 52-week high, and 34% the 52-week low. The exact current I.V. as of Aug. 4 was 35.67%.

To option traders, the fact that the underlying's I.V. is at its lowest levels for the year means that they could be buyers of premium, either calls or puts depending on their directional bias. Once again, I am pointing this out to illustrate how to utilize the I.V. reading, and I am not suggesting the buying of calls or puts.

For the more visual learners out there, below is a snapshot of the same info as given by the CBOE, but this time from the IVolatility Web site.

Again, the line which contains the most essential info that pertains to my point is the very last row of the I.V. table. The chart, below the table, plots the same mathematical numbers visually.

Observe that I have again, below the chart, recaptured the last row of the IV table showing the IV mean data.

The figure above is also a two dimensional figure. It has a horizontal axis that represents time. Each grid square stands for one month. The vertical axis isn't price related, but it is percentage of two types of volatilities. The black line represents the statistical or historical volatility.

The I.V is the green line and also the representation of the market makers' expectations of the underlying movement in terms of percentages regardless of the direction. As it can be observed from the XLF example, both lines were "sitting" on each other in the recent past. This means that the I.V. is low and that the option premium for calls or puts isn't overpriced. In fact, it is undervalued.

As traders, you should always be aware of the implied volatility for products that you are trading options on -- and now you know how.