This post originally appeared here on SeeItMarket where I’m a contributor.
Investors and options traders sell puts and put spreads to generate additional income or acquire stock. In many cases, traders attempt to time their entry by waiting for oversold extremes. Once the market is oversold, they sell out of the money spreads with the hope that the level they’re selling isn’t reached.
Rather than simply look at price, traders can also look both implied and realized volatility to filter candidates for selling puts. The image below ranks the sector ETF’s (plus IWM and SPY) on three criteria:
- First we look at IV – HV, which gives us an idea of how “rich” options premium is relative to recent movement.
- We also look at the IV to HV percentile. That ranking indexes both IV and HV over the past year and then takes the ratio. What we know in looking at that number is that a higher ranking means options premium is rich relative to price movement over the past year.
- The last ranking is an average rate of change. The number averages the price performance over the previous 1, 3, and 6 months. Since we’re interested in selling puts we theoretically don’t want a market that is collapsing and likely to hit the short strike. That being said, some traders might prefer to sell puts in the collapsing market.
The Utilities sector ($XLU) and Consumer Staples ($XLP) are both trading with rich premium relative to the past year even though their raw number for IV – HV is low relative to the other sectors. Additionally, both of those sectors have held up well based on the average rate of change.
For traders who are more comfortable with price risk, the Financial sector is trading with both a high raw premium of IV to HV and a high premium in annual terms. The Financial sector has been weaker in price terms and implied volatility seems to be reflecting that risk.
The important thing to remember is that price is only one part of the picture and we can find unexpected clues about the market when we evaluate volatility.