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Consistent income trading options: Implied volatility and expected move

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In our quest to understand trading options for income, the topic of this article is comparing IV (implied volatility) and EM (expected move) of the option chain.

As traders of selling premium (i.e., credit spreads, naked shorts calls and puts, iron condors, short strangles, etc.) we focus on IV and IV Percentile as an indication of high POP (probability of profit); and this is especially the case when considering an earnings play when IV tends to dramatically rise.

However, since IV is tied directly to DTE (days till expiration) of the option chain, the closer the earnings announcement is to expiration, the higher the IV. In fact, we find that IV can appear dramatically higher simply because DTE is just one or two days.

Another consideration is the relationship between the price of the underlying asset (Apple) and its EM. We can compare the two to see if there is typical ratio, thus removing the impact of price on EM.

Therefore, since IV is questionable around earnings announcement day, would looking at the percent EM to Price provide a more accurate picture of volatility?

To test this, we looked at the following for Apple (AAPL) on the day of earnings announcement (which occurs after the Close): Price; DTE; IV; and EM for 1 SD (standard deviation). We conducted this test from July 2010 through December 2013, or 14 earnings cycles. In addition, we determined the P&L for a strangle NTM (near the money), 1 SD, 1.5 SD, and 2 SD.

The results? First, looking at the average IV grouped by DTE (1 day through 4 days), we see that IV is higher the closer to expiration: DTE 1 is 96.33%; DTE 2 is 105.02% (only one 2-day occurrence); and DTE 3 & 4 range from 70% to 76%. However, the largest average EM was DTE 2 at 34.67; the others ranged from 23.01 through 27.10.

DTE 1 has a very high IV (96.33%), and yet has the smallest percent EM (4.69%) which clearly underscores the problem with focusing only on IV.

Second, the highest percent EM in the grouping was DTE 2 (6.75%) which also had the highest IV (105.02%), indicating an expectation of Apple making a big move after earnings announcement. As can be seen from the P&L, losses occurred for all levels except 2 SD; Apple did indeed make a big move.

And third, the average EM for all 14 earnings periods is 5.58%, with a min of 4.17% and a max of 7.53%. This average would be a good benchmark for comparison: if higher than the average, use 2 SD; if lower use 1 SD.

In conclusion, a more appropriate measure of volatility when considering a strategy for earnings would be the percent EM (i.e., EM / Price), to avoid distortions associated with IV (due to DTE) and EM (due to Price).

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

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