How to Use Option Credit Spreads and Implied Volatility Together
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But many of you want to know when and how to put these trades to work.
So today, I’m going to start with credit spreads and their relationship with implied volatility.
We’ll start with a quick refresher on credit spreads and implied volatility.
Then we’ll dive into how changes in implied volatility impact credit spreads.
And finally, I’ll give you some takeaways that you can write down on a note card to help you optimize your credit spreads.
Quick Credit Spread Recap
Just as a refresher, credit spreads are defined-risk trades where you:- Sell one or more options contract at one strike price
- All with the same expiration date
- All on the same stock
- All the same type, whether puts or calls
- Buy the same number of options contracts as you sold at a different strike price
- All with the same expiration date
- All on the same stock
- All the same type, whether puts or calls
On a call credit spread, you sell an option at a strike price that is lower than that of the one you buy.
Initiating the credit spread trade, whether call or put, pays you a credit, which is the maximum profit you can achieve for the trade.
Maximum profit occurs at expiration if a stock finishes above both of the strike prices for a put credit spread or below both of the strike prices for a call credit spread.
Maximum loss occurs at expiration when a stock finishes below both strike prices for a put credit spread, or above both option strike prices at expiration for a call credit spread.
Your maximum potential loss is the difference between the strike prices, minus the credit you receive. Effectively, this is your cost to buy 100 shares at the strike price and sell those same 100 shares at the strike price, minus your premium credit for the spread trade.
Implied Volatility Refresher
You can think of implied volatility as the demand for options. When demand rises, option prices get more expensive. Conversely, when demand falls, option prices get cheaper.Implied volatility is mean-reverting. This means that it is more likely to move back toward the historical averages the further it gets away from the mean.
This is an important point that we’ll circle back to later on.
Implied Volatility and Credit Spreads
With credit spreads, we get paid a credit to initiate the trade. Naturally, that means the option we sell has to be worth more than the option we buy.You can see this in the option chain for Cisco (CSCO) below.
In this option chain, we have Cisco’s March 18, 2022, calls down the left side and puts down the right side. The strike prices are circled in green in the middle.
Let’s say we wanted to create a call credit spread. We could sell the $60.00 call for $0.52 and buy the $62.50 call for $0.25. That would pay us a net credit of $0.52 – $0.25 = $0.27 x 100 shares per option contract = $27 per option spread.
Now, what would happen if demand for those options increased?
We know that higher demand means higher implied volatility. And higher implied volatility means higher option prices.
But here’s the key.
Changes to implied volatility have a greater impact on option strikes that are closer to the stock’s current price than those further away.
To help you visualize this, here’s a handy little graph.
This graph charts theta along the y-axis against the stock’s price on the x-axis. The legend shows what call and put options might look like at different implied volatilities.
The current stock price (at the money) is $60. (Remember, “at the money” means the option strike prices are closest to the current stock price.)
Theta is the Greek symbol that measures the amount of time decay for an option. For today, we can consider this to be the extrinsic value of an option.
Refresher: The intrinsic value of an option is the value of an option at expiration. For example, a call option with a strike price of $50 has an intrinsic value of $2 if the stock trades at $52.
Extrinsic value is all the remaining value in an option’s price once you remove intrinsic value. It’s the “time value” of an option, or theta. Using that same example, if the call option with a strike price of $50 trades for $3 and the stock trades at $52, the stock has $2 of intrinsic value and $1 of extrinsic value.
Now, what I want you to take away from this chart are two things.
First, as you move further away from the current stock price, the extrinsic value of the option decreases at a logarithmic rate. (This is the opposite of an exponential rate: Exponential growth starts out slow and then speeds up, whereas logarithmic growth starts out fast and then slows down.)
Second, when you increase implied volatility, it steepens the curve in the middle and the slopes as you move away from the middle.
Bringing It Together
Let me walk you through some logical steps to help you make sense of all this.First, let’s split option credit spreads into two groups: in the money and out of the money.
As I mentioned earlier, we want our options to finish out of the money by expiration to achieve maximum profit.
So, if we create an option credit spread that is out of the money, we want the price of those options to decline as quickly as possible.
Remember how I said earlier that implied volatility was mean-reverting? We can use this to our advantage here.
To give ourselves an edge, we can sell out-of-the-money credit spreads when implied volatility is high. This allows us to obtain a larger credit than we would get when implied volatility is lower.
Conversely, we could simply move our strike prices further away from the stock’s current price.
And guess what happens when implied volatility contracts, as it often does when it gets to extremes?
That’s right: Those option contracts we sold are now worth less, all things being equal.
Now we can exit the trade at a partial profit, even if the stock’s price hasn’t moved at all.
On the flip side, if we have in-the-money credit spreads, time is not our friend. So we want to initiate in-the-money credit spreads when implied volatility is extremely low.
That way, if it increases as it moves back toward the average, the prices of the options increase and our trade is at a theoretical profit, all things being equal.
Keep These Close By
I want to roll this all up for you in a few takeaways.- Sell out-of-the-money credit spreads when implied volatility is high.
- Sell in-the-money credit spreads when implied volatility is low.
- The further your strike prices are from the stock’s current price, the lower the impact implied volatility will have on that option’s price.
Focus on those three basics I listed above and you’ll be well on your way to creating profitable option trades.
Over the next few weeks, I plan to cover more about option spread trading.
But this is just one type of options strategy. What are some others you want to learn about? Iron condors? Butterflies? Strangles? Email me and let me know. While I can’t reply to everyone, I promise to read them all.