It’s critical to have a risk management strategy in place if you want to consistently earn income trading options. To that, you must understand volatility; specifically, how implied volatility can help us decide whether a trade is worth our time and money – or not.
The role of implied volatility in options trading
Options have two characteristics: intrinsic value and time.
In order to price an option correctly, you need to understand implied volatility, or how much the market expects the price to change. You also need to take time into consideration. Without looking at a timeframe, even the most precise model may not price an option correctly.
When an option is priced based on historical patterns, the price could be very high if a stock has a history of big moves.
Using implied volatility in a real trade
Let’s say we are in front of an earnings report for Chipotle. We know the stock is expensive ($1,900 per share) and that it has made very large moves up and down following the last two earnings reports.
We may see an option at the money trading at 2% of the stock price, or $38. One contract would cost you $3,800. The market is looking for a big move higher, so implied volatility is high. Is it worth it to risk so much capital on a single play?
So now let’s look at the timeframe. The more time you have, the better chance you have to make it to your strike price and an eventual payoff. However, you’ll pay for that time with a higher option price. Again, is it worth it?
Look at volatility through a risk management lens. If volatility is high but a stock is unlikely to move much, the option is overpriced. The stock may make a decent move higher, but if it doesn’t, your losses could be substantial. Can your portfolio absorb a large loss?
In my book, the risk is not worthwhile. The odds are not in your favor. In fact, you might as well just play roulette in Vegas.
Another useful tool in evaluating risk is delta. You can read more about how delta supports options risk management here.
