Application of the 20%/10% Guidelines Within a Broad Range of Implied Volatility Securities – August 16, 2021
I recently published an article titled Managing Implied Volatility Risk by Establishing an Initial Time-Value Return Goal Range. This article served as a catalyst for several inquiries from our members asking if the BCI 20%/10% guidelines applied to high volatility securities in terms of the protection we receive from declining share values. This article will present a case that our 20%/10% guidelines do have broad application as a diverse group of implied volatility securities will be highlighted to show the relationship between IV and Delta.
Definitions
Implied volatility: This is a forecast of the underlying security’s volatility as implied by the option’s pricing in the marketplace. It is generally stated in 1-year terms and based on 1 standard deviation (accurate 68% of the time).
Delta (as defined for purposes of this article): This is the amount an option value will change for every $1.00 change in share value. The greater the chance of the strike expiring in-the-money (with intrinsic-value), the higher the Delta.
20%/10% guidelines: Sets up protocol as when to buy back the short calls and is based on the total option premium originally generated. We buy-to-close (BTC) when premium declines to 20% or lower of the original sales price in the 1st half of a contract and 10% or lower in the latter half of a contract.
Technical reason the 20%/10% guidelines have broad application among a wide range of IV securities
High IV securities tend to have high Deltas resulting in a quicker movement to reach the 20%/10% thresholds. This is precisely what option-sellers want when highly risky securities are declining in value as it allows us to take more immediate action.
Securities to be evaluated
- Amplify Transformational Data Sharing ETF (NYSE: BLOK)- high implied volatility
- Vanguard High Dividend Yield Index ETF (NYSE: VYM)- low implied volatility
- SPDR S&P Oil & Gas Explore & Prod. ETF (NYSE: XOP)- moderate implied volatility
Option-chains for BLOK, VYM and XOP for similar out-of-the-money (OTM) strikes
- Brown cells on the far right indicate the OTM strike price
- The brown cells in the middle of the screenshots indicate the implied volatility ranging from 14% to 72%
- The yellow cells represent the Delta stats ranging from 0.1 to 0.72
Takeaways
Higher implied volatility securities tend to have higher Deltas and vice-versa. This will allow us to take more immediate action relating to our position management arsenal when share price of risky securities begin to decline in value.
A change in implied volatility should not be confused with these conclusions
A rise in the implied volatility of a call will decrease the Delta for an in-the-money option, because it has an increased probability of moving out-of-the-money, while for an out-of-the-money option, a higher implied volatility will increase the Delta, since it will have a greater probability of finishing in-the-money.
Discussion
Our 20%/10% guidelines have broad application among a wide variety of implied volatility securities. This relates to the fact that Delta plays a mitigating role.
Author: Alan Ellman