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Consistent income trading options: Implied volatility and return on capital

Implied Volatility and Return on Capital
Implied Volatility and Return on Capital

In our quest to understand trading options for income, the topic of this article is to compare the impact that IV (implied volatility) has on ROC (return on capital).

As sellers of premium (ex., strangle, short call or put, iron condor, credit spread) a key metric impacting the ROC is IV, for two reasons: First, as IV increases, option premium increases as well for a given strike. And second, the increase in IV also helps move the position of our short strikes further OTM (out of the money) for the same POP (or level of risk); the expectation being that IV will eventually decline which will increase the POP (probability of profit).

Throughout 2013 IV has been historically low, near the bottom of its IV Percentile of 10% (i.e., its position within the annual range of IV). This has changed in 2014, with IV increasing from 12% to over 16% (and IV Percentile over 60%); an increase of over 33% ( (16 - 12) / 12 ).

We would expect at a given level of risk, for example 1 SD (standard deviation), that the premium collected will increase. How much it will increase is what we want to determine, so Options Annex conducted a test of the SPX starting with a low IV of 12%, and then increasing IV 5 points to 17%, then 22%. As we increased IV, we adjusted the position of the short strikes to maintain a POP of 68% (which is 1 SD).

To accurately measure ROC, we will be using a $25 wide credit spread for each leg of an IC (iron condor). This sets the capital at risk for a single IC at $2,500. All other variables are kept constant: price, DTE (days till expiration), etc..

The results (see the Table)? At our baseline IV of 12%, the premium for the IC was $2.08 for a 8.32% ROC . When the IV rose to 17% (an increase in IV of 42%), our premium increased to $2.80 for a 11.20% ROC (an increase in ROC of 34.62%). At an IV of 22% (an increase in IV of 83%), our premium increased to $3.93 for a 15.72% ROC (an increase in ROC of 88.94%).

In conclusion, as IV increases so does the ROC. In fact, the percent increase in ROC quickly overcomes the percent increase in IV once IV exceeds 20%. This means we are able to improve our returns for the same POP, thus decreasing our effective risk (premium goes up while the theoretical level of risk of 1 SD remains unchanged).

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