Options Trading: HOW TO PROFIT FROM STOCK MARKET VOLATILITY | Scott Reese | Skillshare

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Options Trading: HOW TO PROFIT FROM STOCK MARKET VOLATILITY

teacher avatar Scott Reese, Engineer & Investor

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Taught by industry leaders & working professionals
Topics include illustration, design, photography, and more

Lessons in This Class

6 Lessons (1h)
    • 1. Introduction

      1:33
    • 2. Historical Volatility

      8:20
    • 3. Implied Volatility

      14:17
    • 4. Implied Volatility Overstatement

      19:41
    • 5. Trading Demonstration

      15:30
    • 6. Wrapping Up

      0:44
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About This Class

If you've ever spent even a small amount of time watching or trading in the Stock Market, you've likely witnessed just how volatile and chaotic it can be at times.

Volatility is the enemy for a lot of traders and investors. But not for option sellers! 

In this course, you will first learn about historical volatility and implied volatility. Then you will see how the discrepancy between these two concepts gives option sellers the advantage in the market! And finally, I will show you the kinds of trades you should be making to turn this advantage into profits!

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Scott Reese

Engineer & Investor

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Transcripts

1. Introduction: If you have any experience with the stock market, whether you have just purchase your first share of some company or you're a 20-year trading veteran. Or maybe you just like to tune into financial media every now and then. Chances are you've seen firsthand just how volatile, how chaotic the stock market can be at times. But did you know you can actually trade and profit from that volatility as an options trader, that is exactly what I do every single day. And this course will show you exactly how I do it. And specifically you're going to learn about the concept of historical volatility and implied volatility. And the very interesting discrepancy between these two concepts. And it's this discrepancy that actually allows options traders like myself to literally trade and profit from the volatility, they chaotic movements of the stock market. And the really cool thing about this kind of training strategy is you don't have to care at all about direction, right? I'm totally indifferent whether stocks go up, down, sideways, or in circles because any movement in any direction is quite literally volatility. And the more volatile the stock market is, the more profitable that's kind of trading strategy becomes. And if this is the first course of mine you've come across. My name is Scott Reese. I currently work as both a software engineer in the financial services industry. And I'm also an entirely self-taught and self-directed investor and trader. And it's my goal here with this channel that I've create on skill share, to have other people take control their finances, to become self-taught and self-directed investors and traders also. And so if you want to learn a completely new way of thinking about and trading the markets, or maybe you're just looking to expand your knowledge. And then we'll have options trading. Then I'll see you in the next video. We're going to kick things off by talking first about the concept of historical volatility. 2. Historical Volatility: All right, welcome to the first video of this course where I'll be discussing the concept of historical volatility. And this video here is going to serve as a foundational piece for the videos coming up later in this course, where I'll be then discussing how to actually take advantage and profit from volatility in the stock market. And so the concept of historical volatility is actually very simple, and it literally means exactly how it sounds, right? We're just gonna be looking at the up and down swings or the price movements of a certain asset in the past. And so what you're seeing here in this chart is a one-year price action chart of daily price moves for the asset SPY, which is just an ETF that tracks the S and P 500. So in essence, this chart here is showing you the daily price moves of the entire US stock market. And so you can tell obviously just by looking at this chart that there are certain periods of times where the volatility or the price movements of SPY are much larger and more chaotic than other time periods. For example, if we come back to February and March and April when the shock of the coronavirus pandemic hit full force, we saw the US stock market basically totally crash from peak to bottom. It was about a 30% drop. So this is obviously a huge down move, a huge price swing in the US stock market. And so just thinking about this conceptually or intuitively, obviously this would be a very volatile or very chaotic time, even as things started to recover, right? Obviously, there were still certain time periods where there were much larger up moves or down moves and other periods, right? We can see right in here, the up and down moves are pretty small. So the volatility of the market during this time period is rather low. And then shortly after we got this huge up move, which then ended in a pretty big down move, and so on and so forth, right? As the market continues forward, there's always going to be up and down chop, so to speak. The market never just moves in a perfectly smooth line, either up or down or sideways. Whatever destination is headed towards is gonna get there by moving in a pretty choppy manner along the way. And so conceptually speaking, this is all historical volatility really means, right? We're just looking at the up and down moves the swings in the stock market in the past, which obviously can come in different sizes and speeds. But to get more specific, historical volatility is actually something we can quantify, put into a number. And so if I come over here, the more specific definition of historical volatility is simply the percentage change in the price of an asset over a certain interval of time. And the interval of time can be anything. We can look at the historical volatility over a one day period, over a one week period, a month, a year, ten years, it doesn't matter. We simply need a specific interval of time. And then from the beginning of that time period to the end, we can calculate the percentage price change. And that number is actually how we can quantify the historical volatility of the asset we're looking at. So to help make this a bit more concrete, and they come over here and I have a spreadsheet that I want to show you and I'll be coming back to the spreadsheet a couple of times throughout this course to show you different things. But what I have here is 20 years of daily price movements of the asset SPY, which is what we were just looking at in chart form. And the data I have here goes back all the way to October 16th of the year, 2 thousand. And if I were to continue scrolling down all the way to the bottom, we would get to October 16th of the year 2020. So 20 years of daily price movements for SPY. And in case you're wondering, I got this data from Yahoo Finance, it's very easy to go into their website, type in the ticker symbol of an asset you are looking for. And then you can specify the time interval and the frequency of the historical data you want to download. So 20 years of daily price movements is what I downloaded and then I just imported that into the spreadsheet here. Very simple. And so Yahoo Finance will give you obviously the date, the opening price of SPY on this specific day, the high of the day, the daily low, the closing price, and the adjusted closing price, but they will not give you this column here. This is something I had to calculate manually, but Excel makes this process very simple and easy. And so this percentage change column, all it does is it shows you literally the percentage change of the prices of SBY over a one-day period. So for example, if we look at the adjusted closing price of SPY on October 16th of the year, 2 thousand SPI closed at $94.35. And then the following day on the 17th, the closing price was $92. So obviously spy had a downward move of $2.35, but in percentage form, that is a negative 2.49% downward move. And then from October 17th to the 18th, we can see spy moved from 92 down again to $91.66. So the percentage change here was negative 0.37%. And then the following day, spy had a pretty big up move, which in percentage form is a positive 3.77% move. And calculating these numbers is actually very simple and straightforward. So for example, calling back up to here with the negative 2.49% down move. The way we calculate this number is we simply look at the corresponding day's closing price and we subtract from it the previous day's closing price. That's step one. And I'll actually put the calculators to do this for you. Slowly move it down here. So again, we take $9,000, right? The corresponding day's closing price, subtract from it the previous day's closing price. So $94.35, that gives us negative 2.35. And then we take this result and divide it by the previous day's closing price. So negative 2.35 divided by 94.35 gives you negative 0.0249, et cetera, et cetera. And then lastly, to get this into a percentage form, we just multiply it by 100. And that gives you a negative 2.49% return, which is obviously reflected right here. So very simple and easy. And so now if you think back to the more specific definition I just showed you of historical volatility. These percentage price movements are literally the daily volatilities of SPY in the past. Now when it comes to actually taking advantage and trying to profit from volatility in the stock market. I personally don't really care about the day-to-day fluctuations, the day-to-day volatility of whichever asset that I'm looking at, because its price fluctuations are just too small. And I'll get much more in-depth on this later in this course. But I personally care much more about the month to month volatility in the stock market or the percentage price movements over a month to month period. And so if you wanted to calculate the historical volatility of SPY over a month long period. It's going to be a very similar process to doing it on a daily time basis. So for example, I wanted to look at the historical volatility over the month of November of the year 2 thousand. Then we're gonna wanna look at the price change in percentage form between November first and November 30th, right? Because we want to see how much SPY moved over a full 30 days. And so to calculate the historical volatility over this month or the percentage price change. Let me pull out the calculator again. All we're gonna do is go to the corresponding I'd just a closing price on November 30th. So coming over here, it's going to be $90.31. So let me type that in $90.31 and then we subtract from that the closing price on November first, which is going to be $97.27. So we subtract 97.27, that gives you negative 6.96. Then we just take this number and divide it by 97.27. So let me go ahead and do that. Divided by 97.27. And that gives you negative 0.07, 1-5, et cetera, et cetera. And then finally, we multiply this by 100 to get it into a percentage form. And so that gives you negative 7.15%. And so this would be the historical volatility of SPY over the month of November in the year 2 thousand, from beginning to end of that month, SPY dropped by 7.5%. And so that's all there really is to it when it comes to historical volatility. It's a very simple concept and it's very easy to actually quantify. And so in the next few coming up, we're gonna be discussing a very similar topic. And that topic is going to be implied volatility. And it's going to be a little bit more complicated than historical volatility, because implied volatility is basically looking into the future as opposed to the past. But the cool thing is that there's actually going to be a discrepancy between implied volatility and historical volatility. And this discrepancy is one of the things that gives options traders, specifically options sellers, a major advantage in the stock market. So whenever you're ready, I'll see you the next one. Thanks. 3. Implied Volatility: Alright, we'll come back to the next video in this course. And so now we're going to be taking a look at the concept of implied volatility, which is very similar to the concept of historical volatility. But the main difference here is implied volatility is trying to accurately predict the price movements of the stock market into the future, as opposed to looking at them in the past. And this is where things can get a little bit more complicated, right? Because if we're looking at the historical volatility, obviously we have historical data to accurately calculate what that volatility really was. But going into the future, right, we have no data, but as you'll see, we're still able to make pretty accurate predictions of the volatility of the market in the future. But first I want to come over here and give you the more specific definition of implied volatility, which I've added to our sheet here. And so specifically implied volatility, also referred to as IV, is the expected percentage change in the price of an asset over a certain interval of time in the future. And so I intentionally wrote this definition to be very similar in format to the historical volatility definition because like I said, these two concepts are very similar. But like I said, we're looking at the expected move in the future when it comes to implied volatility. Now this is the more simplistic definition of implied volatility. It does get a little more complicated in the full in-depth definition of this concept because there are things involved like standard deviations and other statistical terms. I'm not going to get into that in this course. So for the purpose of this class, I want you to just have this definition of implied volatility in your mind. It's simply the expected move of a certain asset over a given period of time in the future. Now when you're looking at implied volatility data for a certain asset, it's typically going to be a stated on a one-year basis. Meaning, let's say I'm looking at SPY for example. And I see that right now the implied volatility for SPY is 26%. And so what that means is one year from now, SPY is expected to be up or down from where it is today by 26%. And so this is another detail you want to remember here in that implied volatility specifically is referring to the expected percentage change in the price of an asset, either up or down from the current trading price. It's basically giving you an expected range of movement. And that's because that's simply the best that we can do when trying to make predictions about something into the future. It's way too difficult to make a prediction saying that OK, the expected move for SPY a year from now is up by 26% or down by 26%. The best we can do is give an up or down range plus or minus 26%. And the cool thing is that for broader US market, ETFs are indexes like SPY. There were actually other indexes like the VIX, for example, that will show you the implied volatility for SPY and all the fluctuations that had over the past. Because implied volatility is a very dynamic phenomenon. It changes on a daily basis depending on what's happening in the world, what's happening in the market, what the news is, what people's expectations are, implied. Volatility can grow and contract very quickly. And I'll show you a demonstration of that here in a minute. But for the last bullet point here, I just want to mention that if you're looking at individual stocks, right? Not broad market ETFs are indexes. The way you get the implied volatility number is by looking at the option prices for that particular stock. And you're trading platform should do all this for you. And that is basically going to use the Black-Scholes equation, which is used to price options. And using that equation, it can literally calculate and back out the implied volatility for the specific stock you're looking at. So now coming back to my trading platform here. And so as I was saying for broad US market ETFs or indexes, we can go to the v6 now type in VIX, And that will pull up the VIX index. And the VIX specifically shows you implied volatility for the S and P 500, there are other implied volatility indices for the nasdaq index, for example, the Dow Jones index. So just keep in mind the VIX only refers to the S and P 500. And so we can see right now the most current value of the VIX from the previous day's closing price is 27.41, which again would mean one year from now, the marketplace expects the S and P 500 and to be either up or down by 27.41%. Very simple. But you can see by looking at this chart here that there are times in the past where the VIX were implied volatility had huge expansions, huge spikes, especially here back in February and March, and other times where it contracted very rapidly, the VIX or implied volatility can really be all over the place again depending on what is going on in the world, in the market at that time. So if we do go back to late March, right at the peak of the VIX here at 85.47. That means at this time, on this day, there was so much chaos in the market that a year from this point, we expected the market to be either up or down by 85%. That's a huge number. And so this high occurred right around March 17th, March eighth or so. And if we go to the SPY chart and go to that same date and going to March 18 or so, we can see that when the VIX had its peak, the stock market, as shown by SPY here, had its bottom. And this is very indicative of the relationship between implied volatility and the asset that it tracks. Meaning in this case, when the SPY or the US stock market has a huge crash or a big downturn, you are most likely going to see a pretty significant spike in implied volatility. Because think about it conceptually or logically, when the market goes down, that usually happens because there is some pretty bad news that just came out. And people tend to panic and freak out a bit while they're trying to process that news. So during these few weeks when the coronavirus pandemic shock hit full force, nobody had any idea and we still don't really have a good idea. But especially during this time, no one had any clue of how the coronavirus pandemic would affect the economy, the Stock Market, jobs and all that stuff, people's lives, et cetera. And so during this time, it was just sheer panic. And so of course in moments of complete panic and fear, the expectation of what's going to happen a year from now is going to be even more uncertain, which is why the expected range of the US market a year from now, or a year from this point in time was plus or minus 85%. But as we gather more information on the virus and we learn more how to treat it. And we were able to assess more accurately how the pandemic is going to affect the economy both on a domestic and international scale. And of course, as the Fed got involved, the market started to recover very swiftly. And if you go back to the VIX chart now, we can see during that time the VIX definitely contracted very significantly along the way as well. Of course, they're a little spikes here and there. But for the most part during this period, as the market recovered, the x contracted. And so I hope this is a pretty good illustration of just how chaotic the stock market can be at times. And that just a few weeks prior to this, everyone was thinking the market could literally crashed by 85%. And then literally a few weeks later, now people are thinking, okay, the market's going to be up or down by 27%, which is a very more realistic number. Just like I was saying earlier in this video, when we are looking at implied volatility for broader US market indexes are ETFs. We have other indexes like the decks to show us the implied volatility over a certain period of time. But when it comes to individual stocks, you have to look at the actual option prices to figure out what the implied volatility is. So for example, if I now go to Twitter stock, if you look down at this chart right here, this is showing you the exact same information that the VIX index was shown you for SPY is a simply a graph showing the implied volatility for Twitter stock over the past year. And we can see as of right now from the previous day's closing price, in regards to the options, we are able to calculate that the implied volatility for Twitter stock is 68.75%. So again, over the next year, as of right now today, we expect that Twitter is going to be up or down by 68.75%. And of course, just like the VIX, there are times where the implied volatility for Twitter contracts and where it expands. Because again, people's opinions, people's level of fear or panic and the events that are happening in the world certainly change on a day to day basis. And so if you do want to start trading options or you want to start trading options, the way I do that, I would definitely make sure that whichever trading platform you are using has a graph that shows you the implied volatility for any individual stock. Because trying to calculate these numbers by hand from looking at the option prices is going to be extremely, extremely difficult. And if you've ever seen the Black-Scholes equation, you'll know exactly why. It's like I said, my platform here, the some platform, we'll use the Black-Scholes equation and apply it for me to the option prices on Twitter and calculate or back out the implied volatility for Twitter stock. And the reason it can do that is because implied volatility is one of the major factors that goes into pricing the value of an option. And specifically as implied volatility expands when you get a spike like this that is going to increase the price of all the options, both the calls and puts and as implied volatility contracts, that's going to decrease the prices of all the options. And I'll get more into this later in this course. But understanding that information is incredibly important for your success as an options trader. But moving on, the last thing I wanna show you before I wrap up this video up. So I come over to our spreadsheet here again. If I scroll over to the left, I have the exact same kind of information that you solve for SPY, 20 years of daily price movements for the VIX index, right? So from October 16th of the year 2 thousand, all the way to October 16th of the year 2020, I have the daily price moves for the VIX index. And again, I've got all this data from Yahoo Finance. We have the opening price for the VIX, the high, low, close, adjusted close. And then of course, I've also calculated the percentage changes on a day-to-day basis here. Now, as I mentioned in the previous video, there is going to be a discrepancy between the implied volatility of an asset, in this case, for the biggest of the US stock market and the actual historical volatility of that asset. And I'll get much more in-depth on this in the next video. But like I was saying, this discrepancy gives a major advantage to the options seller out the option buyer, it actually puts them at a disadvantage. But for the options seller, it puts them in a huge advantage. And so just to give you a brief demo of what I mean by this, let's look at the v6 closing price on October 16th of the year, 2 thousand. And we can see here it was 26.79, again, meaning that by October 16th of the year 2001, we expect the SMP 500 to be up or down by 26.79%. But did that actually happen? What was the actual move of SPY in his case, over that one year period was at 26.17% exactly. Was it less than, that? Wasn't more than that. Well, we can use our historical SPY data to figure that out. So let's go ahead and do that. So just like you saw in the previous video where I was showing you how to calculate the daily percentage changes or the month to month percentage changes of SPY. I'm gonna do the exact same procedure for a one-year time period. So the first thing we need to do is go to October 16th of the year 2001. Smith scroll down here, and it should be right here. And we can see the closing price of SPY on that day was $76.03. So let me pull out the calculator here. So Sandy, $6.03 was the closing price on that day. And then we scroll back up and now we look at the closing price on October 16th of the year, 2 thousand, which was $94.35. So we subtract this from 76.03. So minus 94.35, that gives us negative 18.32. Then we divide this number by 94.35. Go ahead and do that. And that gives us negative 0.19. And then finally, we multiply this by a 100 to get it into a percentage form. So the actual historical move, SPY over that one year period it was minus 19.42%. But the VIX, right, the actual marketplace at this time, on October 16th to the year 2 thousand was expecting SPY to move up or down by 26.79%. So you can see clearly here that the implied volatility for the US market was significantly overstated. The expected move was much greater than the actual historical move. And what you'll find is most of the time this happens, implied volatility, the majority of the time overstates the actual historical volatility of whichever asset you're looking at. And before I continue here, I do want to mention just one thing. The VIX index technically tracks the implied volatility for the S and P 500 index, not the actual S&P 500 ETF, also known as SPY. Now I wanted to download the historical data for the S and P 500 Index. And the ticker symbol for that is SPX. But for some reason I couldn't download that data from Yahoo Finance. Their data was corrupted in some way and I could not be downloaded, so that's why I had to instead use SPY data. Now of course, the SPY and the SPX both track the same exact thing, the US stock market, but because they're two different products, right? This is an ETF and the SPX is an index. There's gonna be some slight discrepancy in the percentage changes on a daily, monthly, or yearly basis. But those discrepancies are not going to be nearly significant enough to actually have a serious impact on the analysis that we're doing here. So in reality, if I was using the SPX data and I want to calculate the actual historical move over this one-year period. It might come out to 19.2% or negative 19.8%, something like that. But point being in either case, we can see that the VIX had still significantly overestimated the move of the US stock market over that one year time period. So just wanted to clarify that for a second here in case you are wondering why I'm using the v6 data and SPY data and not Vicks and SPX. And it's like I was saying the majority of the time, the implied volatility for any asset in the market, and I literally mean any asset the majority of the time, the implied volatility is going to overstate the historical volatility over any given time period. And it's this discrepancy which gives the option seller the huge upper hand over the option buyer. And so in the next video, like I said, we'll get a lot more in depth on that specific topic and show you why that is. And I think it'll be very interesting for you to c. So whenever you're ready, I'll see you in the next one. Thanks. 4. Implied Volatility Overstatement: Alright, thanks for joining me here again in the next video of this course. And so now we're going to take a deep dive to look at the discrepancy between implied volatility and historical volatility. And as I briefly showed you at the end of the last video, I showed you one instance where the implied volatility for the S and P 500, as shown by the VIX index, was actually overstated when we actually went and looked at the actual move of SPY over that one-year period, right? And so the first thing I'm gonna do in this video is I'm actually going to prove to you using real market data that indeed the majority of the time implied volatility is actually overstated. That what the market typically expects in terms of a price move over a certain period of time, It's actually more than what is actually going to happen most of the time. And so to give you some background, context and hungry to do this, if I come over here, this should be familiar. We have our spreadsheet here again showing our daily price movements of SPY and the BICS. And I did add daily here just to make it more explicit, because if I scroll over here, I had the same kind of data, 20 years of price changes, but now on a monthly basis, both for the VIX and also for SPY. Now it really doesn't matter what kind of frequency you are using for your dataset, whether you are using daily data, monthly, quarterly, annually, whatever, when you're looking at the discrepancy between implied volatility and historical volatility. Because regardless of the frequency you are looking at, implied volatility is going to overstate historical volatility the majority of the time. However, as I stated earlier in this course, my style of options trading typically focuses on the month to month volatility of the stock market. When I sell options, for example, I typically like to do so around 45 days until expiration, so a little bit more than one month. But unfortunately, Yahoo Finance does not offer a 45 day frequency kind of dataset. So getting the monthly data is as close as I can get, but this will do just fine. And so what I'm gonna do is if I come over here, I have written up a little computer application that's going to take in this monthly SPI data and this monthly v6 data. And it's going to figure out how many times in terms of a percentage, the implied volatility for the S and P 500, as shown by the VIX data here, overstated the actual move of SPY. And specifically the wave's gonna do this is it's going to look at the implied volatility, the expected move over each month in this 20-year dataset. And then it's going to compare that expect to move with the actual move of SPY over that same month. So for example, if you focus on the month of November to December of the year, 2 thousand, we can see that on November first, the closing price for the VIX was 29.65. Again, meaning by November first of the year 2001, we would expect SPY or the S and P 500 to be up or down by around 29.65%. However, my computer application wants to know the implied volatility just over this one particular month, from November to December, not for one full year. And so fortunately, there's actually a very simple way to compress this number here to get it from a one-year time bases down to just a one month time basis. And the way I do that, and I'll put the calculator just to show you. The way I do this is I take the number of days between November first and December first, which is 30 days. So I take 30 days. I divide it by 365, or 365 days in a year. That gives me 0, a2, et cetera, et cetera. I then take the square root of this, and then I finally multiply it by the implied volatility, 29.65, so times 29.65. And that gives me 8.5 basically. So 8.5% is the expected move, either up or down, just over this one month period. And so this is the exact calculation by computer program is going to do. And then coming over here is going to use the SPI data between that same month, between November first and December first. And it's going to calculate the actual percentage change that occurred over that one month. And just by looking at this visually here, we can see that spy change from $90.31 on November first, and then by December first, it dropped to a 9.57. So less than $1, which is clearly less than an 8.5% change. So right off the bat in this first month of our data set here, the implied volatility, the expected move of SPY was greatly overstated. And then my computer program is just going to continue on. Then it's going to look at the implied volatility from December to January. And it's gonna run that same calculation to take the, the v6 data, which right here is 26.85. It's going to compress that to just get it over a one month time period. And then once again, it's going to look at the actual spy return between December and January and figure out if once again the expected move was overstated and it will just repeat that process all the way through this entire 20 years of data here. And then in the end is going to output just some summary statistics for us to look at. So now if I come over here, this is the terminal where I'm going to run this application. Don't worry about all this stuff up here. These are just the arguments for my program. So once I press Enter, it's going to output all the relevant information. So I'll go ahead and press enter. First thing it's gonna do is it's going to print out the results from every single month of that dataset. So for example, looking at this one right here, between January first of 2020 and February first 2020, the expected move of SPY was plus or minus 5.49% and the actual move was minus 7.92%. So this is actually one case where the actual move of SPY was greater than the expected move. And we can actually see that happening again in the following month, right, between February first and March first of 2020, the expected move was up or down by 11.31%, but the actual move was minus 13%. And this probably isn't very surprising since it was in this time period where the market totally crashed from the coronavirus pandemic shock hitting full force. That was a very unexpected event. But then we can see from March to April of this year, the expected move is plus or minus 15.6%, but the actual move is only 13.36%. And then from April to May, the expected moon was plus or minus 9.8%. The actual mode was about half that, and so on and so forth here. And then finally we get down to these summary statistics were the most important thing that I want to direct your attention to is this one right here. The percentage of time more the implied volatility was overstated and it came out to be 84.5 to 2% of the time, the expected monthly move was greater than the actual move. So that is basically the vast majority of the time, obviously not all the time as you just saw for the month of February to March, but 84.5% of the time implied volatility is going to overstate the actual volatility, the historical volatility of, in this case, the S and P 500. And then we can see down here, for all the times were the implied volatility was overstated. The average amount that the expected move exceeded the actual move was 2.59%. So for example, if over one month the expected implied move was plus or minus 10%, that means on average the actual move was about 7.4%. And for the few times where the implied volatility actually understated the historical volatility where SPY moved beyond the expected range, the average amount that SPY move beyond the expected move was just 0.23%. So even in the cases, even in the few cases where implied volatility is actually understated, on average, is not understated by very much. And I hope this is a bit eye-opening for you considering the stock market is one of the most efficient marketplaces around. And yet when it comes to imply volatility, when it comes to expectations about the future, the marketplace consistently overestimates the volatility going forward into the future. And so why is this? In my opinion, there are two reasons. The first reason is because of the human factor, right? Even though the stock market is an insignificant way run by computers and algorithms, there is still a huge human element that goes into pricing all the stalks and options and other financial products in the financial marketplace, right? And it's in human nature to overestimate the downside of something happening. For example, if you've ever given a presentation in school before the presentation, you might have been a bit nervous but anxious and you may have had thoughts like, Oh my gosh, I'm not gonna do very well. I'm not as prepared as I should be. This is gonna go terribly, blah, blah, blah, right? The fear and uncertainty in your head tends to expand a bit when you are in an anxious or nervous state. But once you do that presentation, as long as you are somewhat prepared for it, chances are your classmates and your teacher or going to tell you that you did a great job. And that might come as a complete shock to you because you thought going into their presentation, we're not gonna do well. But in reality, what actually happened is you did quite well. Maybe it wasn't perfect, but in reality, you still did a very good job at your presentation. And that same kind of concept applies exactly to the stock market when it comes to assessing the future, what may or may not happen. Humans tend to overinflate the possibility of negative outcomes occurring, which is why even though the entire marketplace is very efficient and pricing, because it is still mostly dominated by humans and human psychology. The market forecasts about the future as shown by implied volatility, are going to assume that bad things are gonna happen more frequently and with greater magnitude than what is actually going to happen in real life as time unfolds. That's why the majority of the time, the expected moves, whether you're looking on a month-to-month basis, a day-to-day basis, the year-to-year are almost always going to be greater than the actual moves when they do happen. The second reason is a little bit more technical, and it has to do with options sellers. Specifically when you are selling a naked option, like a naked call or Naked Put, you have no immediate protection when things move against you. So for example, if someone in the marketplace buys a call option on Apple, that option buyer could technically make it infinite gains on that option, right? There's no limit on how high Apple can go. And so as Apple continues to move higher, if it does, that option buyer is going to be continually making more and more money. Which means on the flip side, the options seller is going to be continuing to lose more and more money. And again, since there is no cap on how high applicant go, there's also no cap on how much the options seller can lose on that position. Now of course, the options seller can buy that option back and cut losses and run. But stocks can move very quickly and losses can be racked up faster than you might think. And so because of this unlimited risk component for the options sellers that are going to want to charge a little bit of extra premium. The prices of this options a bit higher than they should be in order to compensate them for that undefined risk. And as I stated earlier in this course, implied volatility is one of the major factors that goes into pricing an option. And specifically as implied volatility expands, as it gets greater, that's going to increase the price of options. And as implied volatility contracts that's going to decrease the price of options. And so options sellers are going to sell their options at a price that once you actually use the Black-Scholes equation to back out the implied volatility from those prices, you're going to see that the implied volatility is a bit inflated. Again, to help compensate those options sellers for the unlimited risk that they're taking on by selling those options. So those are the two main reasons why implied volatility is consistently overstated. We've got the human fear factor and options sellers needs an added incentive to take on unlimited risk. And so now to get a little bit more in depth, because implied volatility is overstated most of the time. That's going to give an edge and upper a hand to those options sellers. Because if implied volatility is typically inflated, that means auction prices are typically going to be inflated as well. And options, both calls inputs are going to be priced greater than where they should be based on what they're genuinely worth, right? If, for example, if I'm looking to sell options on SPY and based on the current market conditions and the actual true risk in the marketplace. And one way to get an estimate of that is to look at the historical volatility of SPY. What is the S and P 500 actually do on a day to day or month to month basis, the exact fair price for one of the options, maybe a far out of the money call or for out-of-the-money put should be maybe 80 bucks. But because implied volatility is one of the major components that goes into pricing that option. And because implied volatility is most the time overstated, I actually might be able to sell the option not for 80 bucks, but maybe for a 100 bucks or a 120 bucks. So as an option seller, I am almost always selling an overpriced product, which will one, increased my profits on average. And two, if I do take on losses, if I do have traits that move against me, and I certainly will from time to time, I can use the extra credit, the amount of money I sold that inflated option for to help offset any of those losses. And moreover, this means as an option buyer, you are almost always overpaying for that option. So just by buying a call option or by buying a put option. Almost 85% of the time you are automatically giving the upper hand to the options seller. And if you ask me, that is not a position that I want to be in. And so this is why my entire options trading system consists almost 100% of selling options. And I say almost a 100% because if I want to define my risk on a position, right? Because just selling a naked call or selling a naked put has undefined risk associated with it. If I wanted to define that risk and say that, okay, I don't want to lose more than exactly 350 bucks. You can actually buy an option as well as protection. But even in doing that, that kinda position is still going to be a net short position, meaning I have still taken in credit. I've taken in money from actually selling an option, and I've just purchased a much cheaper option as protection. And so regardless of that little exception, everything that I do is strictly options selling. Because I know that the moment that I placed that trade, The moment I sell that option and someone buys it from me, I immediately have the upper hand. Now of course, bad things can still happen, right? 15% of the time the stock is going to move beyond the actual expected move and I will lose money on those occasions. But I would much rather be on the side where 85% of the time I had the upper hand. Moreover, on top of this, if I go back to our spreadsheet here again, and let's go back to the daily data. So over this 20 year time period of daily price movements for the VIX, we can see that 53.47% of the time the VIX actually moved down in price from the day previous. Alright, so this number just comes from looking at all these percentage changes and just calculates the percentage of the time where this change was negative. And we can see that obviously it was more than half the time. Obviously 53.47% is not a huge amount over 50%, but this is still another way the options sellers have an edge in the marketplace. Because think back to the fact that as implied volatility contracts, that's going to decrease the price of options, right? And so if I sell an option, let's say for a $100, I know that more than half the time over the course of that trade, as the days and weeks go by, volatility is most likely going to be contracting along the way, which is going to decrease the price of that option. Which means at some point down the road, I can buy the option back for a cheaper price than where I sold it and make the differences profit. So if I sold it for a 100 and then just by volatility contracting alone, over maybe the course of two or three or four weeks, I might be able to buy that option back for 50 bucks and then obviously make a $50 profit. So implied volatility gives the options seller basically to imbedded edges. The first one is implied volatility is most the time overstated, which is going to inflate the prices of those options. That's why you want to be selling them. And then secondly, over the course of your trade, implied volatility is most likely going to be contracting, which is obviously going to help your traits become more and more profitable as I just explained, then of course conversely, as the option buyer, right? Not only did you pay extra money for an overpriced product, but the longer you hold that contract for, the longer you hold that call option or that put option. Because implied volatility is most likely going to be contracting over the course of that time, you're going to be losing money. And the reason why the VIX or implied volatility contracts more than half the time. Is because the S and P 500 or the stock market as a whole goes up the majority of the time, right? Obviously people will not invest in the stock market if over a long period of time the stock market was not steadily moving higher and higher. Obviously, there are big recessions and crashes in the short-term. But if you look at the stock market over a 5102050 year period, the market is generally moving higher. And as you saw previously in the course, the stock market and apply volatility basically have an inverse relationship. If the stock market moves down, especially very quickly and abruptly, implied volatility is going to spike and go higher, which obviously is going to work against you if you're an option seller. But the majority of the time, the stock market is moving higher, which means as the market climbs higher, volatility is going to be contracting, going lower. That's just how the relationship works. And we can see this exact same relationship both on a daily scale and if I come over here and also on a monthly scale as well, 53.75% of the time from my 20 years of monthly data here, the VIX is contracting. And once again, that's because the majority of the time going to our spy monthly data, 62% of the time, the stock market moves higher on a month-to-month basis. And the last thing I want to mention here before I wrap this video up is implied volatility is still just one of the major benefits that options sellers get to enjoy. One of the other major benefits that's somewhat related to imply volatility is also time decay. And what that means basically is simply by the fact that time is moving forward with each passing day. That by itself, regardless of implied volatility, regardless of what the stock does, regardless of anything else. Just because time is moving forward, that alone is going to deteriorate the value of options, all options calls and puts. So once again, just to kind of tie all this together, as an option seller, I am one almost always selling an overpriced product that is automatically giving me an upper hand over the option buyer to imply volatility is most the time contracting, which is going to help me as an option seller to make profit. And then three, simply because time is moving forward, that is also going to decrease the price of the options that I've sold. Which combined with the contraction of implied volatility, is going to accelerate the deterioration of the value, that option, which is going to allow me to buy it back sooner at a lower price than where I sold it and make profit. And of course, the sooner I can do this, the better, right? The less time I can have a position on to have my money exposed to risk, the more quickly I can make my profits. That is always going to be a beneficial thing. And so I hope this video illustrated to you here very well that if you do want to get involved in options trading, options selling is where you want to be. You always want to be the seller and the buyer, unless of course, for that one little exception. And the only time where you buy that option is simply as a form of defining your risk. And in case you're curious, you can watch my other options, trading strategies courses to see how that works. And so in the final informational video coming up next, I'm going to be showing you a brief demonstration of how I typically do this on a day-to-day basis. How I go into my trading platform and actually sell options to take advantage of all the things that I've shown you in this video. Implied volatility overstatement, implied volatility contraction most of the time. And also the third little bonus thing that I mentioned, which is time decay. So I'll see you the next one. Thanks. 5. Trading Demonstration: All right, welcome back to the final informational video in this course where I'm gonna be tying everything together and showing you some real life examples, some demonstrations of how you can actually take advantage of the fact that implied volatility is most of the time overstated. So coming in here to my thicker some training platform, I'm going to come over to the Trade tab. And what I had pulled up for you already is the option chain for SPY, right? Just the ETF that tracks the S and P 500. And as I've stated already, I generally like to sell options with at least one month left to go until expiration. So looking at these options here, I would pull you wanna come down to the November options that expire on the 20th, 28 days. I generally like to stay away from the weekly options because for individual stocks, the weekly options are very illiquid most the time, meaning there's just not a lot of people training them and it's very hard to get in and out of trades and to get filled a good prices. Now for SPY, FOR broad market ETFs that weeklies are still very tradeable there, very liquid. But generally speaking, I do just prefer to stick with the monthly contracts. So I begin with these November 20th options, but you'll notice if I come all the way over here, these numbers specifically looking at this first one right here, shows you the actual implied volatility number that has been backed out from the options that expire on November 20th, right? Remember, the actual implied volatility is a number that is mathematically calculated out of the prices of these specific options that you're looking at here. So this implied volatility number 27.59%. Now this is stated on a one-year basis as it usually is. We don't care about the expected move of SPY over the next year. We only care about what SPY is expected to do over the next 28 days until this November expiration. Now fortunately, this next number i here in parentheses, this will show you based on this one-year implied volatility number, what the expected move of SPY is just over the next 28 days. So we can see here that by November 20th, SPY is expected to be up or down by $21.40, and I'm just going to round it up to $22 just to give us a little bit more buffer on either side of the current stock price. So for example, if you look right up here, this is the current trading price of SPY and the market is open right now. So these numbers are going to be changing a bit. So we're just gonna round up and say $344. So come expiration on November 20th, the market is expecting SPY to be up around $22 more than $344 or $22 less. So if I pull out the calculator here, we're just going to take $344, the current trading price, SPY, we're gonna add 22. So this is the upper bound by exploration, right? The market does not expect SPY SV above $366 per share. And then if I take 344 and I subtract 22, this would be the lower bound by exploration, right? The market does not expect SQRT below $322. And this is all again based on the implied volatility from the option prices. So now what this means is if I go into the actual option chain, if I scroll down here. So on the left-hand side, these are all the call options that you can be trading on SPY that expire on November 20th, 28 days. And on the right-hand side, these are all the put options. And you can see all the individual strikes right here. There's certainly are a lot of them. But as we just saw the expected move come exploration by November 20th. $366 on the upper end and $322 on the lower end. So what that means is I can sell both a call and a put option with strike prices at exactly 366322. So let me go ahead and do that and scroll down here. So on the upper end, $366, that's the strike right here. This is the call option we want to be selling. And then for the put side by scroll up and come right to $322 for the strike price. So this is the put option I'd want to sell. And before I set this order, you can just notice right off the bat here just how far away is options are from the current treading price? Spy, which means that over the course of the next 28 days, these next four weeks, SPY has a huge range that it can move in and his options will still remain out of the money come expiration, meaning they'll expire worthless and look at the keep the full amount of money that we sold them for. So let me go ahead and actually set up the order now. So come down here and we're going to sell what's called a strangle. This means we're just going to be assigned both a call and a put at the same time. You can see we're going to sell one contract of SPY expiring November 20th, strike with 366 call option. And then same kinda thing down here, selling one contract on SPY. That's going to be a put option, but I gotta change the strike here. It's going to be a strike of 322. So right there and I can see over here if we are to confirm and send and actually send the order, I'll be able to sell both this call option and put option four right around second round up and call it $500, which I think is a very fair price. And so now keeping in mind right, that the expected move, the implied move, is 85% of the time overstated. And since we've sold the options with strikes right out the expected move, that means the vast majority of the time if I were to keep making trades like this, the options that I'm selling, both the call option and put option here would stay out of the money come expiration day. Those options would expire completely worthless and I would get to keep the full $500 that I sold them both four. And moreover, keeping in mind that around 15% of the time the actual move over the course of whatever expiration cycle you're trading in, the actual move will exceed the expected move. But as you saw in the previous video, the average amount that the actual move exceeds the expected move is very small. And so just for the sake of argument here, let's say that when I place this trade, I sell this call option and put option that come exploration. This trade is going to be a losing trade. That SPY and his case is actually going to move beyond the expected amount. So for example, over the next four weeks, let's say that SPY just has a huge rally and goes from $344 where it is now, and goes all the way up to $370 per share. So blows past or call option here by a full $4. So in this scenario, right? Or put option would be way, way, way far out of the money and come expiration, it would expire totally worthless. So we get to keep the full amount of money was sold as put option four, which is right around 380 bucks. But our call option here. Would be losing money. So on expiration day of SPY was all the way to 370 because our call strike is at 366, we would lose 400 bucks on that part of the trade. But don't forget, we still took in almost $500 of credit initially when we put on the trade. And we can use this money to help offset any losses that we might incur should the market actually move beyond the expected amount. So even though our call option here would lose 400 bucks in this hypothetical scenario, because we took in $500 of credit initially, in the end we would still walk away with $100 of profit. So a lot of the time, even when you are wrong in the sense that the market or the stock that you're looking at actually moves beyond the expected range. You could still be right and still walk away with a profit. Now of course, if SPY just blows past 370 and goes all the way to 375 or higher than, Indeed we would have to start losing money on the trade at 375 or call option here wouldn't be losing $900. And if you only took in 500, that means in the end we will lose 400 bucks. But I want to direct your attention to the fact that the chance, the probability that SPY actually does go all the way to 375 by exploration and come over here is only just under 4%. There's only about a 4% chance that SPY has that kind of a monster move. Moreover, each one of these percentages here, these are all probabilities that correspond to a certain option expiring in the money. All these probabilities are based on the implied volatility of SPY, which 85% of the time is overstated, which would mean a 5% of the time these probabilities are overstated. So the chance that SQL goes all the way through 75 most the time is not a 4% chance. In reality, it might be a three or two or 1% chance. And if you ask me, I'm certainly willing to take on a two or 3% chance of losing a few 100 bucks for the opportunity of making $500 and having overwhelming odds in my favor. And so the last thing I want to talk about here before I wrap this video up is this example that I've shown you here by selling this call option and put option. This is just one way you can take advantage of implied volatility being overstated. You don't actually have to look at the expected move and place your strikes exactly at that expected moved to be a profitable option seller. And that's because all of these options here, every single one on both the put side and the call side, they're all still priced based on the current level of implied volatility. And so if they're all priced using this same thing, which is overstated, that means all their prices are gonna be overstated the majority of the time. So for example, if I instead wanted to get bullish on SPY and not just be a more neutral right? As long as SPY stays below three 66 and above 322, this strangle would make money. And so that's why I call it a more neutral strategy. But if I was bullish than what I could do is sell just a naked put option. So instead of selling that call, I could just sell this put option here by itself at a strikethrough 22, which would Soviet right at the expected move on the downside. Or I could come a little bit closer to where the stock price is trading for. They become to the 328 strike put and sell this one instead. And you can see if I were to sell this IB taking in right around 500 bucks, again, the same exact price as the strangle that you saw just previously. And the reason why I can do this here is again, because these probabilities and these prices here, they're all based on a factor that is inflated the majority of the time. This option here supposedly has around a 30% chance of expiring in the money. Meaning there's supposedly a 30% chance that SPY could drop below 328 come expiration in four weeks. But in reality, the true probability, the true chance of that happening is maybe around twenty seven, twenty six, twenty five percent or even lower. There's no way to know for sure. But what we do know for sure is these probabilities are most of the time inflated and so are the option prices. So this put option here, which is trading for right around 500 bucks, should in reality actually be price maybe around four hundred fifty four, twenty four hundred, because that will more accurately reflect the true genuine risk in the market over this expiration cycle. But instead they're priced at just under $500. And so this is a real example of the fact that as a seller, I could come in and sell an overpriced product and the person buying this from me, it would be overpaying for it. And then don't forget that over the course of the expiration cycle, over the course of the next 28 days here, implied volatility is most likely going to be contracting, which is going to decrease the price of the options here. And I'm referring to both the put options that you're seeing as well as the call options. On top of that, you also have time to K, right? So as time marches forward, as each day passes, that's going to did here at the value of all these options. And moreover, and this is the third way that an option seller can make money, especially when you're using more directional trades like just selling a naked put or selling a naked call, you could get the direction, correct? Right. If you're bullish and SPY and you sold this put option, that means the higher SPY goes over the next 28 days, the less and less valuable this option is going to be. So if, let's say in the next two weeks, SPY goes from 344 to 360, the price of this option might drop by 200 bucks, let's say. And so now if you can combine all three of those things, right, getting the direction correct, implied volatility, contracting, and time to k. Those three things working for you are going to really help weigh the value of this option so that you can buy it back for a much lower price. Of course, you could wait all the way until expiration to collect the full 500 bucks that you sold as put option four, I personally don't like to do that. I much prefer simply buying back the options once the prices have dropped far enough. And I've had some experiences where I've sold a naked put just like this, I got the direction right. Implied volatility contracted significantly and obviously time decays always working no matter what. And I've been able to close positions like this literally in 24 to 48 hours sometimes. Because when all three of those things that are working for you at the same time, the value of options can literally be cut in half or more in a 12 or three day time period. Does that always happen? Of course not. But when you do have traits like that, it's certainly very enjoyable, right? And lastly, in regards to this position right here, this naked put, even though a technically as a bullet position, right? Ideally, you want SPY to go up in price, but of course that does not actually have to happen. All that has to happen for you to keep his full 500 bucks is by exploration, is SPY above $328? And right now it's at 344. So even if SPY goes down or goes sideways, you'll still have implied volatility contraction working your favorite, most likely, you'll still have time to k working in your favor. And come November 20th in this case, you would still get to walk away with 500 bucks. And I just want to reiterate that point because it's so well illustrates why I prefer to trade options over anything else, especially stock. Because the stock trading world, let's say you are just buying stock for various companies that you're interested in. The only way you can make money is that the share price goes up from where you purchased it, right? If I was just buying shares, SPY $344 per share or the only way I can make money is if spy goes to 345 or 346 or 360 as the only way. Now if you're also a little bit more fancy with stock trading and you know how to short sell stock, make money when stock prices go down and price, again, that's the only way you can actually make money on those trades. You have to get the direction, correct. That stock price has to go down, otherwise you make no money. But in the options trading world, specifically if you are selling out of the money options like this, even when you're wrong, you can still be correct, even when you're bullish and the stock goes down or it goes nowhere, you can still make the full amount of money that you expect it to make anyway. And you can give yourself very high probabilities of making that money. And you can take advantage of the market mispricing these products, which has been a phenomenon since the inception of options. So in my opinion, but I hope I've demonstrated this to you wellness cores, but in my opinion, options trading gives you so many more advantages, so many more different ways of actually making money in the financial markets, there are way more different kinds of strategies you can employ. Whether you want to get directional something, whether you just want to be neutral on something, you can give yourself very, very high probabilities of making money on trades. And even when you're wrong and you can still be right. So I hope you enjoyed this video and in the final video coming up next, I'll just be wrapping things up and sending you on your way. So thanks for watching. See you next one. 6. Wrapping Up: All right, so at this point you have finished the course. I hope you are able to learn a lot from it until he gets started trading stock market volatility. You can take a look at the course project down below. And of course, if you have any questions or you need clarification on something, please do also post in the discussion section below as well, and I'll get back to you as soon as I can. And I do always appreciate any feedback that you may have so I can improve my courses going forward. And so with that being said, thank you so much for watching this course. I am scout recent game. I do try and publish one new course every two weeks, and I encourage you to check out the other courses I haven't skill should already have a lot of content already published on general stock market investing concepts, options trading courses, as well as computer science Florida topics as well. And lastly, please do also follow me on skill share so that you'll get notified every time I come out with a new course. So thank you again for watching and happy trading.