Using Implied Volatility to Establish Reliable Trading Ranges for Our Option Contracts – February 07, 2022
PLEASE SEE A REVISION TO THIS ARTICLE AT THE END OF THE POST. I MADE AN ERROR AND REVERSED THE NUMERATOR AND DENOMINATOR IN ONE OF MY CALCULATIONS. THE CONCEPTS ARE ACCURATE BUT THE MATH NEEDED TO BE TWEAKED.
I have written several articles on the use of VOLQ (Nasdaq-100 Volatility Index) to establish a trading range for Invesco QQQ Trust (Nasdaq: QQQ) when writing our option contracts. Many members of our BCI community have inquired about a more universal application using implied volatility (IV) stats to accomplish similar results for all stocks and ETFs. The answer is yes, and this article will use a real-life example with Copart, Inc. (Nasdaq: CPRT).
Initial stats and strategy procedure
- 7/19/2021: CPRT trading at $140.15
- Use standard IV stats to determine an annualized projected price movement based on market option pricing
- Convert that annualized IV stat into one specific for the current option timeframe (days to expiration or DTE): 32 DTE
- Calculate the projected price range based on the IV specific stat
- Check the option-chain to see if we can generate a premium that will bring the breakeven down to the low end of the range while still generating enough time-value premium to meet our goals
Implied volatility of CPRT on 7/19/2021: 20.23
Converting the annualized IV stat to a 32-day IV where the August 2021 contracts expire on 8/20/2021
- The formula we use is: Annualized IV/ (Square root of 365/DTE) = 32-day IV for CPRT
- 20.23/Square root of 365/32) = 20.23%/3.38% = $4.74 higher and lower than current market value
- The projected range during the August 2021 contracts is $135.41 – 144.89
- Next, we view an option-chain to see if we can generate a minimum premium of $4.74 which will both bring us down to the low end of the range ($135.41) and also have a time-value component that will meet our strategy goals (10% – 15% annualized, as an example)
Option-chain for CPRT on 7/19/2021
Our objective is to generate at least $4.74. The $140.00 strike falls short ($3.50), and the $135.00 strike is more than we require but will more than suffice if the time-value requirement meets our goals. Let’s calculate using the BCI Elite Covered Call Writing Calculator/ multiple tab.
Our best calculator for both calls and puts
CPRT: 1-month calculations for the August 2021 contracts
The calculator shows a 1-month initial time-value return of 1.1%, 32-day return, 12.5% annualized which does meet our goal range of between 10% and 15%.
Discussion
A reliable projected trading range can be calculated using implied volatility stats and a conversion formula. When we have a low-end of the price range breakeven met by selling call option premium while still having a time-value component that meets our goals, we will have created a low-risk/high reward approach to option-selling.
Math Revision
The formula for the expected trading range using IV is shown in the screenshot below. In the case of CPRT, the 32-day IV is [(20.23) x (sq.root of 32/365) = 5.99%.
5.99% of 140.15 = an expected price movement of $8.39 in both directions as shown in our BCI Expected Price Movement Calculator:
Author: Allan Ellman