FAQ Section

Pricing & Volatility

Does implied volatility (IV) always overstate the expected move and why should I care?

Yes. Long-term option pricing and implied volatility always overstates the expected move of the underlying security. The more often you make trades the more that IV will overstate the expected move. Of course there will be one-off outliers in all stocks occasionally where the underlying moves 2X or 3X the expected move (the “black swan” type of events) but those will not hurt you overall if you stay consistent and keep your position size small. Nobody, including you or us, can predict these events so the only way to live through them is to keep your positions small and try to enter as many uncorrelated trades as possible so that one or two trades that go bad doesn’t blow up your account.

How do I know if I’m taking in enough premium on a short credit spread?

With short credit spreads you should be taking in a premium that is equal to the risk in the trade times the width of the strikes. For example, let’s say you are selling at $50 strike put and buying a $49 strike put to create a bullish put credit spread and you take in a net credit of .20 per spread. If the probability (or risk in this example) of the short $50 strike going ITM at expiration is 30% then you would actually need to be taking in a credit of .30 for this $1 wide spread for it to be “fair” pricing. Risk in the trade is 30% X width of the strikes of $1 = .30 credit needed. By only taking in .20 of premium and risking .80 when you lose there is rarely an opportunity to make money long term when the probabilities and pricing numbers play out over hundreds and hundreds of trades.

What is the relationship between probability of success and overall return on a trade?

The simple answer here is that as your probability of success increases your overall return, or the compensation you get for taking on risk decreases. Logically this makes total sense in an efficient market as there would never be an instance where a higher probability of success and less risk equaled a higher return. Everything is fair and efficient in our markets. The more risk you take on and the higher probability of success you have for a trade the less you’ll make. Naturally there is a sweet spot where you can balance risk and reward and at Option Alpha we feel that “zone” is around a 1 standard deviation or 70% chance of success target for our trades. We feel this gives us the best balance of winning enough long-term while also making enough money to generate a decent return.

All my small profits are wiped out by one big trade that goes bad - how do I break the cycle of losing big after gaining a lot of small profits?

Here's the deal, we have 100% assurance that IV always overstates the expected move with options which means that long-term the small winners always beat out a couple big losers here or there. Again this isn’t theory or assumption it’s based on hard market data. When it comes down to it though you have to ensure that you are not trading too large on each position and staying consistent and persistent trading high probability setups. Sometimes you get a bad string of trades and there is no way to avoid this completely because it happens. However, you just have to realize that if you make enough trades over time you will hit your targeted probability win rate. So, if you are aiming for 70% chance of success trades and you only make 10 trades all year, well then sure, you might not see exactly 7 winners and 3 losers. But if you make 1,000 trades you’re going to see your winners much closer to the expected 70% just based on the law of large numbers. Finally, when we account for the over-expectation of IV what we actually see is that many trades placed at the 70% chance of success level actually end up winning by a higher percentage, say 80% of the time when the positions actually play out. Again, you can’t fight with the math - it's a game of numbers and probabilities.

What constitutes a high implied volatility trade?

High implied volatility trades are set ups when the IV rank of the underlying stock or ETF is at least the 50th ranking or higher. Naturally the higher the IV rank the more theoretical “edge” we have as an options seller.

Which option strategy benefits from faster time decay the most?

The option strategies that benefit from faster time decay include all naked and short premium strategies. This would be limited to straddles, strangles, and any short single leg options which don't have long components. These options will decay at the fastest possible rate and without the long spread components see the most premium and the highest returns overall. This is further confirmed on our live performance tracking page where we consistently see the most money and the highest win rates with short premium and option selling strategies.

Why is theta important to know as an options trader?

Theta with regard to options trading gives us an idea of how much money each contract is losing on a daily basis because of time decay. Because all options become less valuable as time erodes, theta is always a negative number when shown on a broker platform. Theta will also increase in velocity as the time until expiration draws closer. It's important to remember that theta is like a slow drip from a bucket of water that is constantly draining the funds or value of an option contract. For example, an option with a theta of -.06 means that each day regardless of the underlying market movement, that option contract will lose $6 of value due purely to the passage of time.

If I want to trade volatility which symbols are best for a pure volatility play?

The two best ways to trade volatility directionally either up or down is to trade either the VIX or VXX. Both are very liquid and will give you a more pure directional play on overall market volatility.

What is a one standard deviation (1 SD) move?

A one standard deviation move encompasses 68% of the expected move of the sock range in the future. This is a statistical measurement of the probability and variance going forward into the future at a specific time. When it comes to stock and options trading a one standard deviation move on a stock that is currently trading at $50 might be $5. This means that 68% of the time going forward into the future the stock will trade in a range five dollars above and five dollars below its current price at $50. This also means that 32% of the time it will trade outside of that expected range. Using this information we can then build option strategies to profit based on these probabilities and statistics.

When trading a credit spread why do you buy one option and sell another - overtime won’t they cancel each other out?

No. With a vertical credit spread you are buying one option and selling one option at a different strike price. Over time the reason that you make this trade is because you will profit from the decay in both options but the spread differential between them leaves room for money to be made on one versus the other. For example if you sell one put option for $100 and buy another put option for $80 and they both expire worthless at expiration, you would make $20 or the differential between the two contracts that you bought and sold.

Given low volatility rank - when do you prefer to use a debit spread vs. a calendar spread?

At Option Alpha we like to use debit spreads when we want to be more directional on the stock or need a quick way to hedge our portfolio. With calendar spreads you need significant time in the front month options so if there is less than 20 days in the front expiration contract we will generally use a debit spread over a calendar spread purely based on the amount of time left. Calendar spreads are also great to use when you have a stronger opinion on the possible rise in future volatility. If IV rank is low and you believe that volatility will increase dramatically over the next month then a calendar spread might be a better way to play both the directional move in the underlying stock and the possible rise in volatility.

How can a call option go down in value when the stock price is going up?

This is a common question for new traders because for all intensive purposes you should be making money when the stock goes up right? But in this case a call option can go down in value because of two different things that may have happened. First, implied volatility might have dropped in which case the option price drops along with volatility even if the stock goes up. Second, time decay could have slowly eroded away the value of the option as it moved closer to expiration, again even if the stock goes up.