The next step in the Ultima progression is understanding implied volatility and strike selection. Before we delve into which strikes to choose, there is an important concept called implied volatility skew that is important to understand first.
In part 2 of the Ultima Income Generator, I discussed the concept of buying low and selling high. Not exactly a novel concept, but very important as you look to apply to option trading and implied volatility. The focus in that post was on selling the right expiration and the understanding that higher implied volatility options generally have more time to expiration. That means selling weekly strangles are out. Good riddance!
Ultima Skew
To understand skew, you need to understand that markets crash downward. You’ve probably heard the description of the market climbing the stairs and falling out the window, right? Well, crash risk wasn’t acknowledged by option prices until after the 1987 crash.
For more on the history of skew and vertical pricing check out this post, Skew and Verticals: You’re Either with Me or Against Me.
As you look at the implied volatility of calls and puts on an option chain of an index ETF, you’ll see a pattern. The pattern is that implied volatility falls for calls that are moving out-of-the-money (OTM) and rises for puts that are moving OTM. That means that traders are pricing in a higher probability of a larger downside move and a lower probability of a large upside move. Thus, the climb the stairs fall out the window scenario. In the image below, you’ll see that dynamic.
The chart above reflects higher implied volatility for OTM put options on the left and lower implied volatility for OTM call options on the right. As a result, you expect to see a higher frequency of small upside moves with large potential downside moves.
Ultima Skew Implications
There are two major takeaways from the understanding of skew.
- Puts offer a higher amount of premium than calls
- Importance of hedging the downside risk for premium sellers
Since the premium is outsized compared for puts compared to calls, selling naked puts is a key component to the Ultima strategy. For over a year, the high skew and relatively higher implied volatility has made the premiums from selling puts very attractive. Last year was great for put sellers since there were very few selling events. However, our approach is rather unique and something we’ll cover as we progress through the strategy.
At TheoTrade, Don spends a lot of time introducing hedging strategies and encouraging people to be hedged. In fact, he does a weekly video walking through the ins and outs of the current market. We have many classes on different hedging strategies that have a low entry cost so that it doesn’t distract from the overall return of the Ultima Strategy. However, there are times where more blunt instruments will need to be used.
Skew and Vertical Spreads
People always ask if Ultima involves selling verticals. I know it’s hard to fathom that it doesn’t, but it comes down to understanding skew. Selling put verticals means that you’re selling the lower implied volatility option and buying the higher implied volatility option. That means your return-on-risk is reduced and the price isn’t advantageous.
Conversely, the skew does benefit selling call verticals, but selling naked offers more premium on a product that crashes in the opposite direction.
Conclusion
As we begin to put the pieces of Ultima together, you’ll see that option pricing and skew favor selling more time, selling naked and hedging your risk. These three components are central to the Ultima Income Generator strategy. For our members, this is drilled into them, and they have the resources to help them apply it. Hopefully, this introduction helps guide your thoughts on premium selling.
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