The process of selecting the Options Trading Strategies begin with implied volatility. Key Component in determining an option price is Implied Volatility. Option Price premium is determined with Implied Volatility. Easy way to understand Volatility is that option price and volatility will move in the same direction, keeping all the other things same.
The option price premium is calculated based on the perceived risk that the underlying carries. Implied Volatility is inversely correlated to its underlying. If the underlying goes down the IV becomes higher. At the same time when the underlying goes up the IV becomes lower.
The Risk perceived to be higher when the stock falls. Due to uncertainty in the underlying the IV keeps rising which make the option price higher. Now two things can happen. First the risk can be proved wrong, in that case the stock will move higher and once the stock moves higher the IV falls which is inversely proportional to the underlying and this leads to fall in premium and fall in the price of the option. Secondly the risk perceived proves to be right in which case the stock will fall down, in this case the IV will move higher and this will lead to rise in the premium and rise in the option price.
WHEN DOES THE IV HAS HUGE MOMENTS
The answer you are looking for is Events. Events could be anything right from Earning Reporting, Political Results, Key Statistical Announcements, New of War etc. Sudden impact on the price of underlying and forming a continuous trend leads to huge movements in IV.
The below is the example when the IV Falls quickly when there was a huge bull run post Budget Announcements 2017. With a very short period of two days the fall in the IV was nearly 23%.
WHAT HAPPENS WHEN IV FALLS TOO QUICKLY
- If your Option Portfolio is of Net Long Position and if IV falls quickly, you lose option Premium which leads to loss in your holdings. The fall in the premium is because there are more option sellers than the buyer. The option sellers consists of fresh selling along with option covering. This results in sudden loss in the options portfolio.
- Secondly if your Option Portfolio is of Net Short Positions and if IV falls quickly, you gain as the option Premium which leads to gain in your holding. Caveat is just before an event being of Net Short position carries its own risks.
HOW TO MANAGE WHEN IV FALLS TO QUICKLY
If you are on the Right side e.i. Net Short Position do not wait to milk out the entire profit. Book profit and exit the position. Question comes when you are on the wrong side. Keep it Simple book – loss and Exit.
The next Big Question arises how to tackle or manage such a situation?
The best way to tackle in such a situation is at Strategy level.
HOW TO ADJUST WHEN IV FALLS QUICKLY
Managing is tough since you have already entered the position. But if you want to adjust such strategies when gone wrong then it has to begin with strategy selection. You have to chose Vega Neutral Option Trading Strategy.
Perhaps you have been wondering why you are not getting the desired results from your Option Strategies.
Review your strategy and then go through the article again to have a better understanding. You would have made some fundamental mistakes in selecting the strategies.
If that is the case now is the right time to make necessary adjustments and save from making losses.
Nevertheless, the impact of implementing these corrections the time and other resources you spend in making these adjustments. You might not see more profit with these correction but definitely your capital is not going to erode.
Have you experienced this earlier? With this fundamental change have you corrected your strategy? Would you recommend this to a newbie Option Trader? Let’s hear your thoughts in the comments below!
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Also published on Medium.