Structuring Trades with IV
Saw a few people talking about how to use IV when determining what strategy to deploy or why traders do certain thing's in different IV environments. Below are are a few things to keep in mind when reviewing IV and using it to inform trading decisions.
Option premiums are impacted by a few primary factors: Time, Volatility, and Underlying Price. Strategies react to each of these inputs differently.
Isolating volatility, represented here as IV, and understanding how it impacts premiums allows us to structure trades more logically. As volatility increases, premiums increase. As volatility decreases, premiums decrease. This is because there is less volatility being added to the extrinsic portion of an option's premium.
How do we use it to inform trading decisions? Ideally, we structure trades to benefit from the three primary factors as best as possible. If we're long premium, we want IV to expand (increasing premium of options, driving premium above our basis (barring variations in the other two variables)). If we're short premium, we want IV to contract (decreasing premium of options, driving premium below our basis (barring variations in the other variables)).
So, if we buy a call, we know we want the underlying to go up. However, we can also make money if IV expands. So if we see IVP is very high 95%+ would we want to buy premium here? Maybe, depending on our goals. However, volatility is mean reverting and more likely to contract than continue to expand further (although it certainly CAN continue to expand). In this case, we may choose to change our strategy to something that may take advantage of the more likely scenario, change the product to something that aligns with the strategy we want to deploy, or pass on the trade.
We can increase our overall returns by structuring trades that benefit from price movement and the most probable fluctuation in IV.