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Consistent income trading options: Impact of implied volatility (IV)

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In our quest to understand trading options for income, the topic of this article is to determine the impact of IV (implied volatility) on the price (Mark, or midpoint between bid and ask) on the Weekly SPX with just 7 DTE (days till expiration).

In prior articles, we discussed the inputs to the option pricing model (i.e., Black-Scholes Model). The inputs are: IV, DTE, Underlying Price, Strike Price, Interest Rate, and Dividend. Of all the inputs, IV is unknown; it is derived from the model based on the price of the option. We use IV to determine the expected move (at 1 standard deviation) for the underlying price. This, of course, relies on the daily percent change in the underlying's price to be normally distributed; for liquid underlying assets (like the SPX), this is a fair assumption.

As sellers of premium (i.e., short Straddle, Iron Condor, short Call or Put, credit spread), our positions are generally negative Vega (the position benefits from declines in IV). To understand the impact of a 5-point decline in IV for the Weekly SPX, we looked at the JAN5 14 option chain on January 24th and altered the IV for the chain. The Theoretical value reflects the price of the option as a result of the 5% drop in IV while the Mark reflects the current price based on the current IV of 21.2%. Note: the platform we use (ThinkOrSwim) allows changing IV while leaving price unchanged.

The results (see table above): reducing IV by 5 points (or 23.6% of current IV) led to a considerable drop in option prices: from approximately 45% to 78%. It is also interesting to note that the percent drop is approximately the same for both Call and Put options ATM (at the money), while Call options appear to be more strongly affected as the strike moves further OTM (out of the money).

In conclusion, the results of this simple test underscores the importance of IV; especially for premium selling strategies. The percent reduction in option prices was approximately double the percent drop (23.6%) of IV.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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