As someone who focuses more on premium selling options strategies I am constantly scouring my watch list of highly-liquid ETFs and stocks for opportunities based on inflated levels of implied volatility.
Recently, my watch list has highlighted several glaring opportunities. One such trading opportunity is in the iShares MSCI Brazil ETF (EWZ).
As you can see in the chart below, the ETF has lost roughly 25% over the past four to five months.
As a result of the decline implied volatility, as seen through IV rank and IV percentile, has pushed significantly higher.
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IV Rank
The IV rank for EWZ recently hit an extreme reading. Typically, when we see the IV rank of a highly-liquid ETF or stock hit this type of extreme volatility reading, it marks a potential opportunity to start selling some premium regardless of whether or not one is bullish or bearish on the underlying security.
Courtesy: SlopeofHope.com
Expected Move
Let’s say I wanted to go out roughly 30-45 days until expiration. The December 17, 2021 expiration has an expected move for EWZ ranging between 27.50 and 34.
Knowing what the market anticipates for the expected range gives us a good idea what strikes we prefer to use, especially if we are using a high-probability approach to trading.
Bullish Trade – iShares MSCI Brazil ETF (EWZ)
Let’s take a look at the December options chain for EWZ with 37 days until expiration. Once we have an expiration cycle that we are comfortable with we can then proceed with locating the put strike with approximately an 80% probability OTM (out-of-the-money), otherwise known as the probability of success on the trade. I also want to consider the expected range and attempt to go outside the expected move while maintaining a reasonable level of premium.
It looks like the 27 put strike, with a 74.12% probability of success, is where I want to start. The short put strike defines my probability of success on the trade. It also helps to define my overall premium or return on the trade. While the 27 put strike is slightly below the 80% probability of success that I prefer, the put strike is outside of the expected range for the December 17, 2021 expiration cycle.
Once my short put strike is chosen, in this case the 27 put, I then proceed to look at the other half of a 3-strike wide, 4-strike wide and 5-strike wide bull put spread to buy.
The spread width of our bull put helps to define our risk on the trade. It also tells us how much capital is required for each bull put spread. The smaller the width of the spread the less capital required. When defining your position size, a key element of risk management, knowing the overall risk or capital required per trade is essential.
For our bullish put spread example, let’s take a look at the 3-strike wide spread of 27/24.
The Trade: EWZ 27/24 Bull Put Spread
Simultaneously:
Sell to open EWZ December 17, 2021 27 put strike
Buy to open EWZ December 17, 2021 24 strike for a total net credit of roughly $0.50 or $50 per bear call spread
- Max Return: 20.0%
- Probability of Success: 74.12%
- Total net credit: $0.50, or $50 per bull put spread
- Total risk per spread: $2.50, or $250 per bull put spread
As long as EWZ stays above our 27 strike at expiration in 37 days, I have the potential to make 20.0% on the trade.
In most cases I will make slightly less, as the prudent move (and all research backs this up) is to buy back the bull put spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.50, I want to buy it back when the price of my spread hits roughly $0.25 to $0.12.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we have the ability to take advantage of other opportunities the market has to offer.
Risk Management
Since we know how much we stand to make and lose prior to order entry we have the ability to precisely define our position size on every trade we place.
Position size is the most important factor when managing risk, so keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.
Moreover, I like to take off the trade if my original credit, in this case $0.50, reaches 1x to 2x my credit. So, in this case, I would look to take off the trade if it hit $1.00 to $1.50.
I hope this bullish put spread example helps give everyone a little insight into how a bull put spread works. I will be following up with a short video going through numerous bullish put spread examples. Stay tuned!
Bearish Trade - iShares MSCI Brazil ETF (EWZ)
Like our bullish trade above, let’s take a look at the December options chain for EWZ with 37 days until expiration. My preference is to use options that have roughly 7 to 60 days until expiration. Once we have an expiration cycle in mind, we can then proceed to locate a call strike that has roughly an 80% probability of success.
It looks like the 34 calls, with an 85.08% probability of success, is where I want to start. The short call defines my probability of success on the trade. It also helps to define my overall premium or return on the trade. Basically, as long as EWZ stays below the 34 call strike at expiration we will make a max profit on the trade.
Time decay also works in our favor, so as we get closer and closer to expiration our premium will erode. As a result, we should have the opportunity to take the bear call spread off for a nice profit prior to expiration. Basically, we can be completely wrong in our directional assumption and still make a max profit on the trade. Just another reason why I prefer to sell options over buying them.
Once I’ve chosen my short call strike, in this case the 34 call, I then proceed to look at the other half of a 3- strike wide, 4-strike wide and 5-strike wide spread to buy.
The spread width of our bear call helps to define our risk on the trade.
The smaller the width of our bear call spread the less capital required, and vice versa for a wider bear call spread. When defining your position size knowing the overall defined risk per trade is essential. Basically, my spread-width and my premium increase as my chosen spread-width increases.
For example, let’s take a look at the 4-strike, 34/38 bear call spread.
The Trade: 34/38 Bear Call Spread
Simultaneously:
Sell to open EWZ December 17, 2021 34 strike
Buy to open EWZ December 17, 2021 38 strike for a total net credit of roughly $0.25 or $25 per bear call spread.
- Probability of Success: 85.08%
- Total net credit: $0.25, or $25 per bear call spread
- Total risk per spread: $3.75, or $375 per bear call spread
- Max Potential Return: 6.67%
As long as EWZ stays below our 34 strike at expiration in 37 days, I have the potential to make 6.67% on the trade. In most cases, I will make slightly less, as the prudent move is to buy back the bear call spread prior to expiration. Typically, I look to buy back the spread when I can lock in 50% to 75% of the original credit. Since we sold the spread for $0.25, I want to buy it back when the price of my spread hits roughly $0.12 to $0.06.
Of course, there are a variety of factors to consider with each trade. And we allow the probabilities and time to expiration to lead the way for our decisions. But taking off risk by locking in profits is never a bad decision and by doing so, we can take advantage of other opportunities the market has to offer.
Risk Management
Since we know how much we stand to make and lose prior to order entry we can precisely define our position size on every trade we place. Position size is the most important factor when managing risk, so by keeping each trade at a reasonable level (I use 1% to 5% per trade) allows not only the Law of Large Numbers to work in your favor … it also allows you to sleep well at night.
I also tend to set a stop-loss that sits 1 to 2 times my original credit. In my example, I sold the 34/38 bear call spread for $0.25. As a result, if my spread reaches $0.50 to $0.75 I will exit the trade.
Summary
After looking at both trades, my preference would be to go with the bull put spread as I am able to go outside of the expected move while maintaining a decent level of premium. The bear call spread, while maintaining a high level of probability (over 85%), just doesn’t give me enough premium to make the trade worth it.
Of course, there are numerous other strategies we could implement like an iron condor, jade lizard or numerous ratio spreads, etc., but I wanted to keep it very simple today. Obviously, everyone will have a different idea as to what makes sense given their level of risk tolerance.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below.