OAP 164: The 2 Major Problems With Buying Options During Low IV Markets

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Since we are option sellers and our edge comes from selling overpriced options out into maturity it's natural to assume that if we want to sell options when IV is high that buying options during low IV markets is a way to make money in the other direction. We get it and understand the rationale argument. When IV is low, and option premiums are cheap, you can and should buy options because they are cheap right? Not so fast bargain-buyer. This type of thought process and strategy, low IV option buying, has two major problems. And we don't use the word "major" lightly here. Each problem with option buying systems is so important that the probability of getting both problems right or solved is for all intensive purposes, impossible on a long timeline. Curious to know what these major issues are? Let's dive into today's show and find out.

Key Points from Today's Show:

  • As options traders, we understand that when IV is high, we should be selling options.
  • Now, a lot of people think that when IV is low, you should be buying options.
  • However, our thought process on this has changed throughout the years.
  • Initially, we only sold during high IV markets.
  • But we've looked at our research over the last 5 years and there is still an edge to be gained during low IV markets. 
  • In some cases, the edge in low IV markets is the same as during high IV markets. 
  • We have since made a shift to making trades during all IV markets. 
  • The key is to position size accordingly during low versus high IV markets.
  • However, the stigma still exists which suggests that during low IV markets you have to be an option buyer.
  • When IV is low, you have the best chance of being successful as an option buyer, but that doesn't guarantee that you will be successful.

AQR Research Report

When buying options during low IV, you have two things working against you:

1. You have to have perfect timing

  • Perfect timing is pretty much impossible. 
  • Perfect timing only improves your chances by a very small amount. 

"On average, passively buying Delta-hedged 1-month options loses money on about 70% of every 30-day holding period." — AQR

2. You have to have perfect management

  • Have to be able to pinpoint when to exit the trade. 
  • You cannot hold onto the trade for too long, or exit it too early.

The Long Night of the Portfolio

  • When you buy options using a strategy with a low win rate, but when it wins you win big, you go through a long "night" period. 
  • This refers to the drawdown period of hitting single after single or continuously striking out, waiting for the big win to come.
  • There is no way to predict how long it will take for this win to come.
  • You run the risk of running out of capital before ever winning big. 
  • This is one of the reasons why options buying is not recommended as a core strategy in your portfolio. 

Volatility Bumps Historically

  • Between 1996 and 2018, volatility increased 43% of the time during the month.
  • On average, volatility is going to go up at some point about 4 out of 10 times during the month. 
  • However, only a handful of times was this volatility increase enough to cover the difference between what was expected and what actually happened. 
  • What people expect is always greater than the magnitude of what actually happens. 
  • Although we do see increases in volatility, it just isn't enough of an increase to overcome the overwhelming price advantage that goes to the option seller because of the IV premium.

To view the complete AQR research report referenced please click here.

Option Trader Q&A

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today's question comes from a listener:

In an all-sold or short premium portfolio, how do we protect ourselves against a market crash? If you are negative Delta to protect against your downside but you have all risk-defined positions like vertical spreads and iron condors, how can you protect your downside when our bear call spreads would max profits, but all your bull put spreads would max losses?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.