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Welcome to the second part of my series of articles on the Credit spread. In last week’s article we began to dispel some of the myths associated with Credit spreads, including looking for that juicy ‘Credit’ we are all attracted to, as well as exploring what it really means to have that Credit placed into our account when such a trade is opened.
In this week’s article we are going to look at one of the things that can commonly attract traders to want to trade ‘selling’ strategies, such as Credit spreads - High Implied Volatility. When IV is higher, the premiums in options are higher, and so if we are a net seller of options then we are going to get more premium for our spread when IV is higher than normal.
The first thing the trader may think is, ‘Let’s try to find stocks whose options have high IV’. There are a number of ways to do this. In Optionetics Platinum, this can be done under the Option Rankers area, in Create Option Ranker. This can also be done in the Precomputed Rankings tool, in the Option Rankers area. Through this ranker, it is possible to find the stocks in the market whose IV is at all historical highs. Constructing Credit spreads on these stocks would bring in great premium, and all we would need is IV to crush or revert back to its normal range, and there would probably be an immediate profit in the trade.
Does it sound like there may be a catch here? Of course! We need to ask ourselves why IV is suddenly so extremely high. We could check the news. It may be because earnings are rising, there’s a rumour on the market about the company, be it good or bad, or perhaps the market is waiting for some major news from the company to hit the market. Whatever the reason is, the IV is high because of a market expectation of some movement. The market is expecting the stock to possibly move, there is possibly a rush to buy options on the stock, the market makers are factoring an expected move into the price of the options (by moving the IV up), and traders are buying them.
So now think back to the strategy and risk graph. Do we want to be trading a stock with a Credit spread if we are expecting it to possibly break out? Not at all - if our intention with the spread was to make a little in time decay, perhaps a little from IV crush, and possibly let it expire worthless. If this is what we want the trade to be doing in an ideal situation, then we don’t want to trade a stock that might suddenly gap overnight in one direction.
If our intention with the Credit spread is for the trade to make a little in time decay and perhaps a little from IV crush, then our first point of call in our search should be a stock or index that we DON’T think is going to breakout, or NOT move in the direction of the spread. Then on this stock or index, if we can pick up a little more IV than normal on a day when IV was up a little, then we may get a few extra cents per option.
I’d rather have more winning trades than be trading stocks that may put me into max loss overnight.
Manage your trades!
Matt Baker
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