When IV is low and option premiums are cheap, you can and should buy options, 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 significant that the probability of getting both problems right is impossible over a long timeframe. Curious to know what these major issues are? Let's dive into today's show and find out.
- 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 just as good as during high IV markets.
- As a result of our backtesting research, we have made the shift to selling options during all IV markets.
- The key is to position size accordingly during low implied volatility versus high implied volatility markets.
- The stigma still exists, however, 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 you will be successful.
AQR Research Report
When buying options during low implied volatility environments, you have two things working against you:
1. You have to have perfect trade timing--knowing when implied volatility will increase.
- Perfect timing is pretty much impossible.
- Perfect timing only improves your chances by a very small amount.
"We find that, on average, passively buying delta-hedged one-month options loses money on about 70% of 30-day holding periods." — AQR
2. You have to have perfect trade management--knowing the magnitude of the move.
- Have to be able to pinpoint when to exit the trade.
- You cannot hold onto the trade for too long (theta decay sets in) or exit too early (missed a bigger move).
So, what issues or complications do you face when you don’t get these two trade aspects right when buying options in low IV environments?
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 went up during the month 4 out of 10 times.
- So, why doesn’t option buying work more often? Only a handful of times did the 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 somewhat regular 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.
Click here to view the complete AQR research report.
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 be max profits, but all your bull put spreads would be 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.