How to Choose the Best Options Strategy
In the options trading game, strategy always trumps direction. You have to eliminate the strategies that don't work in the current IV environment so you can focus on the strategies that give you the best possible edge as a trader.
In this video, we're going to talk about choosing the best options strategy for whatever situation you're faced with in the market or whatever situation or setup that you're looking at.
Now, as a reminder, we have proved that options pricing is overstated or rich long-term because implied volatility always overstates the expected move of an underlying stock, ETF, or index.
Therefore, the most important thing that you'll need to understand about options strategies is that it's a process of elimination, not necessarily of selection. Strategy always trumps direction in this game, meaning that you have to be on the right side of volatility to be successful.
Here's how it breaks down, and this is the first level that we're going to talk about, and then we'll get a little bit deeper into how you can choose the right strategy.
It breaks down into these major categories, which is when implied volatility is high, you have to be an option seller more often than you're an option buyer.
That doesn't mean that you can't buy options as part of a strategy, like a credit spread or an iron condor, but you have to be a net option seller when implied volatility is high.
When implied volatility is low, you can be an option buyer. That's where this asterisk is. You can be an option buyer, but just remember that even with low implied volatility, the edge is still for option selling.
It's just that the edge to an option seller has been minimized and is very, very low. When implied volatility is low, you can buy options. That's probably the only time you could buy options.
You just have to remember that you still are going to give up a slight edge to the option seller long-term, so when you buy options, you have to be doing so mainly for hedging your portfolio or protecting a position or if you really, really believe that something is going to turn around or continue directionally.
That's when you would use some options buying strategy. In our case here at Option Alpha, 95% of the time, we are option sellers. Whenever we are option buyers ... so the 5% of the strategies that we do that are option buying strategies is mainly used as a purpose to hedge our portfolio.
We'll enter a long strategy in something to hedge something else that we're bearish in. Just to be 100% clear, most of the things that we do here at Option Alpha is focused on option selling because that's where we know we have our edge in the market. That's where we can generate consistent income.
Now, since we've already proved that you can trade options with the same probability of success and payout in virtually any direction a couple of videos ago here in track number two, the two important questions you should ask yourself are the following ... and we'll start with this first one here.
Number one is, is implied volatility relatively high or low? Probably the most important question you can ask as you start to look for trades and start to figure out which strategy is going to work if you're looking at a particular stock or setup.
Obviously, the next question beyond that is, well, how do we know? How do we know where to look, or how do we know if implied volatility is relatively high or low?
This is where we need to introduce the concept of IV rank as a way to determine if the current implied volatility of a stock is high or low about its past. We always talk about ... an example is a real estate. Real estate is all relative.
Property that's worth $500,000 could be relatively high in your area, where you're living or where you're watching this video right now. It could be relatively low wherever you're living, right?
A $500,000 piece of real estate in New York City is probably really cheap, compared to a $500,000 piece of real estate in the middle of Tennessee or Virginia or Pennsylvania. Exactly. Okay. It's all about relative implied volatility and rank.
Now, what we're going to do in this video is we're actually going to take a look at three different stocks because I think it's going to prove the point that we're trying to drive home that IV rank is actually more important and should be the basis of how you determine if implied volatility is high or low.
More so than actual or kind of the physical hard number that implied volatility is reading because we need to know on a relative basis whether it's high or low.
We're going to look today at Apple stock, Google stock, and IBM, so comparing three different big-name stocks, very liquid, lots of volumes and open interest across the board and look at their implied volatility, the actual number versus implied volatility rank.
First here on the charts, we can see this is Apple. You can usually get the actual implied volatility number somewhere on your broker platform. In Thinkorswim, which is our broker, you can pull it up as a chart. It's in the trade tab. You can pull it up some different ways.
Right now, implied volatility in Apple ... the actual number, what the market is implying that the stock will move in the future, is 25.13%. You can see it here some different places.
Now, visually, you can already see that this relatively low compared to where it's been historically in the past. Now, this is just a six-month chart, but we usually go back about a year or so to see if this is relatively low or high.
Again, Apple's implied volatility ... the actual number here is about 25% right now. It's moving as we're doing this video. I think it was about 24% a little while ago.
Now, Google, on the other hand, has implied volatility that's almost the same as Apple. 24.31% is Google's implied volatility. Now, again, you can visually see that it's relatively low because it's been as high as 40%, going back before, in the past.
It's also been lower than where it is right now at 24. It's been down around the teens or even in the 20s. Okay, so for Google, actual implied volatility right now, or what the margin expects the stock to do over the next year, is move about 24%.
Now, for IBM, we see that it's almost the same as well. Now you see with IBM that implied volatility is 23.91% in IBM. Again, you can see it's low. It's probably not the lowest point that it's been. It's been lower, but it's been higher. It's middle of the range here with IBM.
Now, back on our chart here, or our table, you can see that the actual reading for Apple, just as a review, was 25%. For Google, it was around 24%, and for IBM, it was around 24% as well. On the outside, it looks like all three of these stocks have relatively the same level of implied volatility.
On an actual basis, they do, meaning that the market is expecting all three of these stocks to move about the same amount over the next year. There's no real big difference in price percentage movement that the market is expecting.
Again, what we want to know, is we want to know, okay, for Apple, is this relatively high? Is this 25% that we see here, is that relatively high, or is that relatively low? For Google, is that relatively high or low?
For IBM, is that relatively high or low? For IBM, does 24 ... is that the highest end of the range or the lowest end of the range over the last year? What is the relative nature of that implied volatility number?
That's where IV rank comes in, where we can go back historically and rank this implied volatility number and give it a ranking number, 0-100, to tell us where it is in its historical range.
When we do that ... and again, we can do that here on Option Alpha inside of our new watch list. If your broker doesn't have the ability to do IV rank, we had the capacity here and wrote the code and software to pull IV rank in for all of our stocks on our watch list.
You can see if you just navigate over to the watch list, for example, you can go down to whatever symbol you're looking at. In this case, if we go down to Apple ... and we can see that the implied volatility rank right now is the 13th percentile or the 13th rank.
What that means is that over the last year, if we were to rank Apple's implied volatility on the scale from 0-100, the current reading of 24 sits right around 13 on that 0-100 scale. It's relatively low.
In fact, it's incredibly low, meaning that most of the time, Apple's implied volatility is much higher than the 24-25% that it's right now. Now, scrolling down to look at Google, you can see that Google's implied volatility rank is at the 42nd level.
Again, if we had a scale based on the last year and tracking all the implied volatility numbers that Google had, if we rank them all from 0-100 and place the current level wherever it lands on that scale, it would land at the 42nd level.
That means it's just below the midpoint, meaning it's not quite higher than average. It's just a little bit below average volatility. It's not incredibly low, but it's not incredibly high, either.
It's not at either extreme. Apple is more towards the zero barriers, so it's more on the low end, meaning that implied volatility is relatively low for Apple compared to Google.
Now, finally, if we take a look at IBM, IBM has implied volatility rank that's now at 50. What that means is that, again, if we ranked IBM's implied volatility on a scale from 1-100 over the last year, the current reading is exactly halfway between its highest point and its lowest point over the last year.
Implied volatility in IBM is about average, where it has been all year. It's not incredibly high. It's not incredibly low. It's exactly in the middle, but it also means that we could do something a little bit different as far as starting to trade some different strategies.
All right, so if we go back to our charts now, we can see that if we throw in these implied volatility ranks for Apple, Google, and IBM, we get an implied volatility rank for Apple at 13. For Google, we get an implied volatility rank at 42. For IBM, we get an implied volatility rank at 50.
Now, why this is really important is because all of these stocks on the outside, or to the regular trader who doesn't understand the concept of implied volatility rank or how important it is, would say that all three of these stocks have relatively the same volatility.
The reality is, is that IBM has a much higher level of implied volatility based on its historical past, meaning a reading of 24 in IBM is much higher and much more significant than a reading of 25 on Apple. Apple might generally betile, so a reading of 25 might be low.
A reading of, say, 50 in Apple might be significant. In IBM, which might be just a lower volatility overall stock as far as how much it moves, to see implied volatility right now at 24 is much higher than where Apple is right now.
Again, you have to have some level of relativeness in looking at implied volatility. How we do that is by using implied volatility rank here at Option Alpha. Again, by focusing on IV rank, we can compare all stocks, ETFs, et cetera, on an apples-to-apples basis, not necessarily because we're using Apple, but you get the concept.
Instead of looking at Apple and Google and IBM, and there are oranges, pears and bananas and cucumbers, we can make everything apples to apples and look at one ranking fundamental, implied volatility rank, to tell us which stocks have the highest implied volatility and are therefore the best candidates for selling options.
In this case, it was interesting because Apple had the lowest implied volatility rank, although its actual IV, or its implied volatility, was the highest, making it possibly one of the worst candidates out of the three to start selling options on. It may be the best candidate to start buying options, but the worst candidate to start selling options.
How do we use these implied volatility rankings, meaning how do we help them, or how do they help us determine which strategies we should be going after? In our opinion, our approach to option strategy decisions should be based on an IV rank scaling basis, meaning as implied volatility gets higher and higher and higher, our strategies want to become more and more aggressive towards option selling.
They go from option buying ... in our opinion, anything in the 0-50 IV percentile rank, that should be more of your option buying strategies because you have low implied volatility across the board and option pricing is cheap.
In that case, you'd want to start using things like debit spreads, calendars, ratio spreads, and diagonals, again, because we're playing to where implied volatility is. It's low implied volatility, therefore option buying strategies could work out a little bit better than option selling strategies.
When implied volatility is in the 50th-70th percentile or rank, we need to be more of an option seller, but we don't want to be super aggressive because 50 is not 100, and neither is 70. We still want to protect ourselves.
In this case, when implied volatility is in this area or this range, we want to do more of the credit spreads, iron condors, and broken-wing butterflies and iron butterflies. We want to trade options, still be a net seller of options, but we want to do it on a protected or risk-defined basis because implied volatility could still expand even more.
Now, when implied volatility is up around the 70th-100th percentile, at that extreme high IV level, you want to be doing the most aggressive type strategies as you can. In this case, that would be the straddles, the strangles, and the iron butterflies or wide iron condors.
That could also be thrown in there as well. Again, our opinion should be you should use strategies that work on an IV scaling basis, meaning as implied volatility goes higher, you start selling more and more options on a net aggressive basis.
Let's work through some couple examples here, again, just to get a feel for everything that we're looking at. Now, again, inside of Option Alpha, we have built a watch list that makes it incredibly easy for us to go through and find high implied volatility or low implied volatility trades.
If you want to go in and let's say you just want to target high implied volatility stocks only and ETFs, you can just filter out everything that has low implied volatility. Again, we do the calculations through our software and the formulas that we wrote.
It pulls in all of these numbers to tell you exactly where implied volatility is for any stock that you're looking at. We can then also sort this list by highest implied volatility first, so now if I scroll down here, I can see that basically, my highest implied volatility stocks right now are EWZ, PBR, and MON.
Then the next highest implied volatility set includes Yahoo, eBay, and Netflix. All of these IV ranks are now showing here, and you can see we've kind of color coordinated it so that when something is above the 70th or 50th IV percentile and rank, that it changes color.
It shows you on a visual basis how you can be more successful in choosing the right implied volatility stock. Now, what's cool about this software that we built here with this watch list is that we also built in the capability of telling you exactly what strategies work best for different implied volatility ranks.
Instead of having to go back to these slides and talk about those different levels, we already prebuilt it in here. If you're looking at EWZ and implied volatility rank right now is at 85, the software automatically tells you that these are the three best strategies that you can use.
You can do a straddle, a strangle, or you can do an iron butterfly. It's important to note that we always include an IRA or small account appropriate alternative here, so we will always have three different options available.
You can do the straddle if you're aggressive, the strangle if you're a little bit less aggressive, and if you are in an IRA or a small account, you can do the iron butterfly strategy. They will all work relatively the same in this case for EWZ because implied volatility is the 85th rank.
Now, again, we'll use those same, obviously, strategies for PBR and MON because they're all in the same ranking kind of grouping, so that 70-100 IV rank.
If we go down to Yahoo, you can see that we have a little bit different implied volatility rank in 63, so it's not quite that 70 that we talked about before.
It's not quite as high as 70. It's now between 50 and 70, so you can see that the color changes to a light blue, and now the strategies that we suggest that work best are credit spreads, butterflies, and iron condors.
Again, all of these strategies are not going to be appropriate for an IRA or a small account. They're also great for large accounts. You'll just have to scale up the number of contracts that you have.
Now, let's say actually that you wanted to look for some stocks that had low implied volatility. Instead of going after the high implied volatility, you just want to find ones with low implied volatility.
Well, you would filter off high IV only, and you would re-sort the entire list by implied volatility, lowest to highest. Now we see here that Salesforce, CRM, has the lowest implied volatility rank of everything that we track.
Again, it gives you suggestions on the best strategies, to use the calendars, ratio spreads, and debit spreads in the case of CRM, which is Salesforce. I think the ability to choose a strategy is not necessarily that big of a deal once you understand that you have to be on the right side of volatility.
Again, the way that we built this software in our watch list here is based on all the feedback that we received from thousands of members over the last eight years and understanding that strategy selection is one of the toughest parts.
We believe that we've made it insanely easy to the use of this watch list, so I encourage you to check it out. Use the demo that we have or purchase lifetime access to it.
Now, your directional assumption, whether you're bullish, bearish, or neutral, is the next thing that we have to talk about. Here's the deal. You should be mainly determining your assumption based on your portfolio balance and your beta-weight, which we've previously talked about in other videos here in track two.
Remember, you can skew your positions to the direction that you need to get back to neutral. The concept here remains the same, that implied volatility is the number one thing that you have to focus on.
The second thing that you have to focus on is whether you want to be directionally biased in choosing which way you go with the trade or if you want to stay neutral.
It comes back down to that understanding of what does your overall portfolio need. Does your overall portfolio need more bullish positions or more bearish positions to get back to neutral?
If we look at Salesforce, CRM, here in this example, we could do a debit spread in Salesforce, CRM, in either direction. We could do a call debit spread and trade it bullish. We could do a put debit spread and trade it bearish.
Either one of those would have the same risk and reward characteristics, the same probability of success and payout, but it comes down to asking yourself, "Which one of those strategies do I need most?", meaning, "Which direction do I need most in my portfolio?"
If I've already got 10 bullish trades, maybe I do a put debit spread in CRM so that I have at least one bearish trade in my portfolio to start becoming a little bit more balanced and a little bit more neutral. That's the second part of the strategy selection process.
Thank you again for checking out this video. Hopefully, it's been helpful to understand how we think about strategy selection here at Option Alpha. Again, if you have any comments or feedback, please ask them in the comment box right below.
If you loved this video, thought it'd be helpful for someone else out there, please share it online. Help us spread the word about what we're trying to do here at Option Alpha. Until next time, happy trading.
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