Using Implied Volatility to Screen for Option Trades (Part 3)

Last time I presented a generic screen to identify high implied volatility percentile candidates. Today I will conclude discussion on this strategy.

Criterion #3 searches for stocks with a minimum average true range. Average true range is a measure of stock price movement in relation to the previous close. Generally stocks that move very little have options that are very cheap. While a tradeoff exists, profit potential is generally limited when selling cheap options.

Criterion #4 searches for stocks with current implied volatility (IV) percentile in the top 5% of their 12-month IV range. Being mean-reverting, according to theory, IV will be likely to drop in the near future. Short options will profit when IV falls.

Once the screening is complete, the next step is to inspect the price charts of stock candidates. Any stocks that are at solid support levels are candidates for short puts or put credit spreads. Any stocks that are at strong resistance levels are candidates for short calls or call credit spreads. Stocks that seem range-bound, or trading sideways, are candidates for iron condors or naked straddles/strangles.

For each stock that turns up on the screen, we must be sure to identify the earnings announcement date. IV tends to peak just before earnings are announced. After the announcement, IV crashes. This is good for a short premium strategy. However, stocks tend to make big price moves following earnings announcements too. Depending on how much price risk a proposed trade has, we may want to avoid earnings announcements to decrease risk of earnings-induced price shocks.

Finally, look for news that might signal reason for high IV percentile. Pharmaceutical stocks (especially biotechnology) are notorious for big price moves related to FDA approvals or bans. Similar to earnings announcements, we may want to avoid placing trades if an FDA decision is imminent.