Using Implied Volatility to Screen for Option Trades (Part 1)

Today I will discuss one approach to trading options: screening by implied volatility (IV).

The sheer volume of option trading possibilities can be overwhelming. To find good trading candidates, I need to keep in mind the three sources of option profits: price movement of the underlying stock, option supply and demand (IV), and time decay.

Time decay is largely a function of option supply and demand. As demand for options increases, option prices increase. IV measures how expensive options are in terms of expectations for the underlying stock movement. Higher-priced options have more value to lose over time. This decay is value lost by option buyers and value gained by option sellers.

Profitability is therefore a function of two main factors: price movement of the stock and supply/demand for the options. To make money with an option trade, I can either look for stocks whose prices I can predict or look for stocks whose IV changes I can predict. When I choose stock price change or IV as the primary consideration, IV or stock price change will be the secondary consideration, respectively.

Some people believe changes in IV are easier to forecast than directional movement of the stock. IV is believed to have strong mean-reverting tendencies. Whether or not this is true is something we could research (topic for another day). For now, though, it will be sufficient to say those in this camp believe IV to oscillate around an average value and return to that average quickly when IV strays too far away.

Based on this philosophy, screening for stocks that are at higher-than-average IV levels should be a good source of option trading ideas.

I will continue discussion of this trading approach in the next post.