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Premium Selling in Low IV Environments

I've received a few questions about selling option premium when IV is low.  This is one example:

Mark,

For approximately 1 month stocks have gone up without the volatility that we had become accustomed to in the fall.  At the same time the vix has gone down to approximately 16.

It pays to look at the multi-year picture to get a better feel for what can happen to implied volatility.  We are indeed below long-term averages at this level, but as recently as Jan 2007, VIX was 10.  The point is that we may look back at these IV levels and think of them as being relatively high. I have no idea which way IV will be trending in the coming months.

I usually sell option premium and with such low implied volatility on individual stocks, it has become very difficult to sell premium without being exposed to higher touching or expiring risk to get the same premium.

Those last four words describe the problem.  Whether you are trading credit spreads, iron condors, or even selling naked options, the decision on which options to trade MUST be based on something other than option premium.  Premium is one of the important consideations, but allowing that to be the one and only factor is a big mistake, in my opinion.

I urge you to think seriously about collecting the same premium when that involves taking greater risk.

When IV is low, it's low.  You must accept that fact and adapt your trading habits.  If you want approximately the same level of risk as your previous trading, then there is no alternative: you must accept a reduced premium.

Taking on more risk is always wrong – unless the extra reward more than compensates.  If you must take more risk, trade smaller size.  You are dealing with statistics. Unlikely events will occur at random times.  If you do not trade as if that fact were the gospel, then you must get rich quickly (and then retire from trading) because you have almost no chance of surviving over the longer term.

Positions that originate when already outside your comfort zone have too much probability of not working.  You may not like my answers, but I implore you: 'Please' do not take more risk just because the markets have not been volatile. 

This is a different market, and perhaps a different strategy should be used during these times.  Positive gamma can be added to your premium selling portfolio, but that would cost some cash, and your note tells me that spending money for any options is not something you are anxious to do.

In your webinar (at Trade King, on debit spreads) you discussed how the debit spread was very similar to the credit spread with a small advantage to the credit spread as you can do whatever you want with the cash.

In times of low volatility such as this holiday season how does it impact the strategies?  Selling credit spreads with such low volatility is very likely to result in problems with vega increasing faster than theta decay making it an unattractive strategy.  

More than similar, it's equivalent when the trades are initiated at equivalent prices, using the same strike prices and expiration dates.

You have drawn incorrect conclusions: It's not 'low volatility' that is 'very' likely to result in problems.  It's your personal need to collect the same premium.  You are increasing substantially the probability that those 'problems' will arise.  It is not mandatory to do that.

Remember that premiums are smaller for a good reason.  The market has not been volatile and thus, the expectation is that low volatility will continue. In fact, the market has been less volatile than predicted by VIX, and that's one reason VIX is still trending lower. 

You could be happy with a non-volatile market.  You could look at it as a less-risky situation.  Yes, it offers less profit potential per spread, but it also increases the probability of earning a profit.  What's so wrong with that?  You may prefer the higher risk/higher reward scenario, but that is not what this market is offering.  You have chosen the higher risk/SAME reward strategy.  Surely you must understand that this may work for you, but it is not wise and it fights those statistics mentioned earlier.

One reasonable solution is to alter your methods.  My solution to these 'IV is too low' situations may not suit you, but I try to own positions with less negative vega.  Thus, if I trade iron condors (I do), then I may add some OTM call and put spreads – just to add positive vega and gamma.  That reduces risk. But be sure to add positions that reduce risk, and do not add to it.

Or I may add diagonal or double diagonal spreads to an iron condor portfolio, making it more vega neutral.  You may decide to go long vega – if you expect that IV will increase quickly.  There are alternatives to your chosen methods.

More often I do not sell credit spreads but sell uncovered options further out of the money and this too is very unattractive with low volatility.

This is a strategy with higher risk.  I have nothing extra to say about this except that moving strikes nearer to the stock price is not the way to go. 

Another possibility for careful traders is to sit on the sidelines until finding something comfortable to trade.  You are not forced to trade right now.  As a compromise, trade one half as many contracts as you do now.

We must be prepared to modify our strategies when market conditions make those strategies less comfortable to use.  Flexibility – not increased risk – is the way to prosper.

Please explain your spread strategy preferences pro and con for very low volatility. 

This is more of a 'lesson' than a quesion, and I respond to questions such as this in the comments area (nor via e-mail.

Answer: I trade iron condors in smaller size – i.e., I trade fewer spreads and just accept that I'll try to make less money.  If you are successful, if you are making money, then it has to be okay to earn less when you feel risk is too high.   I also consider owning a portfolio that is far less vega negative.  I also consider buying insurance (naked strangle)

And please explain your spread strategy preferences pro and con for very high volatility.

Again, this reply required a book chapter, and I cannot go into detail here.

Answer: As an iron condor trader, or credit spread seller, I go farther OTM when IV is high.  I do not go after the higher premium.  I anticipate more volatility and move farther OTM to accept the same, or even less credit.  I like being farther OTM and will take 10% less premium to move another strike OTM.  I trade negative vega strategies and  recognize that some months afford larger profit opportunities than others.

For spreads one is always buying and selling volatility.  For deep in the money there is little impact for volatility as there is no time premium, but in most other circumstances one option is being sold and one is being bought and it seems to me that a change in volatility will have in general a similar impact on spreads of nearby strikes.

Similar, yes.  Nearby strikes and DITM strikes, yes.  But when selling OTM spreads, there is enough difference that the spread widens as IV increases.  This is more obvious with put spreads, where the skew curve plays a larger role.

There is no best answer to this situation and there is no set of rules to follow.  There is only good judgment and risk management. 

There is a lot of hit and miss when trading – it is not an exact science.  I suggest avoiding extra risk, even when that means trading less size.  I advise accepting smaller premiums, and maybe taking a trading break.  However, there are appropriate alternative strategies when you believe IV is moving higher. When it is low and you don't know where it is headed, it seems to me that vega neutral trading is the safest path. I know safety is not your current concern.  It's not too late to reconsider.

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