Profit with Implied Volatility (Part V)

In the quest for consistent profitability, my last post continued the “IV primer”  (http://www.optionfanatic.com/2012/04/10/profit-with-implied-volatility-part-iv/).  Today, I want to take the concepts from the IV trades I have been describing and develop them into two general, theoretical concepts about option trading.

I have talked about IV as a measure of how expensive an option is.  I have described long (short) straddles and strangles as trades that profit if the underlying moves a lot (little).  I have described theta as the daily decay of long options.

What is this all telling us?

Concept #1:  when you buy options, consistent profitability requires large enough price moves of the underlying to outpace time decay.  A large move on the first or second day of the trade will result in greater profit than a large move on the 20th or 21st day.  When you sell options, consistent profitability requires time decay to outpace price moves of the underlying.  A larger move on the 20th or 21st day of the trade has a greater chance of leaving a trade profitable than on the first or second day.

Concept #2:  IV is synthetic time.  Focusing on time and assuming all else constant, an option becomes more or less expensive as the time to expiration increases or decreases.  Focusing on IV and assuming all else constant, an option becomes more or less expensive as IV increases or decreases.  An increase in IV is like moving farther away from expiration.  A decrease in IV is like moving closer to expiration.

These are important theoretical concepts describing the gist of option trading.  If you can understand these concepts with regard to the trades I have been describing in this IV primer then consider yourself to be well educated!