Option Selling, or Option Writing as it is popularly known, has always had a high success rate. It is said that almost 2/3rd of the options ever created expire worthless. The profits on Options Writing are made because 2/3rd of possibilities of movement are in Option Writers’ favor.
A Stock can Either
1. Go Up
2. Go Down, or
3. Stay Steady
We all know that with passage of time options premium goes down. Now, if it is Call or Put option we have written, one of the two - Up and Down - directions is going to make money for us. On top of that if the underlying asset does not move significantly then, too, we are going to make money.
However, there is one more element. We have been talking about risks in the options and that when it increases it pushes the Option Premiums up and Premiums drop with drop in the risk in the options. This risk is nothing, but the volatility priced in the Options.
In other words, volatility implied by Options. Options premiums are mathematically calculated. If we know the Option Premium (the answer), and 4 out of the 5 factors that make option premium:
1. Stock Price
2. Strike Price
3. Interest Rate
4. Time to Expiry
The 5th element of volatility can be back calculated for a given Premium. Such Volatility Implied by the Option Premium is called Implied Volatility.
Now, the Implied Volatility (IV) has its own characteristics. Apart from being positively corelated with Option Premium, it also is mean reverting. In short, IV will not go up like a stock from 1 to 100 to 1000. IV moves in ranges. These ranges could get bigger, smaller, higher or lower. By Higher what I mean is that lowest point of the range is also relatively higher and highest point is much higher than recent readings.
Now, to the Blessings and Curse
Mean Reverting characteristics makes these Blessings and Curse happen for the Option Writers
Blessing:
Imagine when we Sold Option the IV was at the higher end of the range. Now, with the Range bound characteristic it is more likely to come down. So now there are double profits
1. Profit Due to Passage of Time
2. Profit Due to Drop in Premium due to Drop in IV
Curse:
Imagine when we Sold Option the IV was at the lower end of the range. Now, with the Range bound characteristic it is more likely to go up. So now there are compensating effects
1. Profit Due to Passage of Time
2. But, Loss due to Rising Premium led by Rising IV
Here, we may even end up losing in Option Writing trade despite the underlying stock or index did not move significantly for a reasonable amount of time due to rise in IV.
Finally, we need to be mindful of the fact that where the IV is before taking a trade so that we capitalize on the Blessings and Avoid the curse.
How Do we Do It?
By checking the relative placement of IV versus its Highest and Lowest Points in last 1 year.
Formula = (Current IV – 52 Week Low IV) / (52 Week High IV - 52 Week Low IV)
If this number is more than 70, it means that IV is closer to the higher end of the range. It means it is more likely to turn into a Blessing.
If this number is less than 30, it means that IV is closer to the lower end of the range. It means it is more likely to turn into a Curse.
Most of the Option Analytics Applications would have this data. Alternatively, one can look at India VIX high and low in 52 weeks on NSE’s website and make this calculation.
This is a popular formula to get IV’s placement in recent time and is known as IVR and used most widely across the globe by Option Writers.
Finally, despite accurate forecast on underlying asset, the IV can crush your trade. On the other hand, IV could accelerate the Returns if placed well. So, Option Writers keep an Eye on Volatility Priced in Premium a.k.a. IV and make it a Blessing for your trade.
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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