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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.
Right now, there are no shortage of ideas as implied volatility is high across the board. One such trading opportunity is in the iShares U.S. Real Estate ETF (IYR).
As you can see in the chart below, the ETF has lost roughly 12.5% since the beginning of the year. In fact, the first trading day of the year marked the year-to-date high.
As a result of the decline, implied volatility, as seen through IV rank and IV percentile, has pushed significantly higher.
The IV rank for IYR 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.
Let’s say I wanted to go out roughly 30-45 days until expiration. The April 14, 2022, expiration has an expected move for IYR ranging between 95 and 109.
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.
Bearish Trade – iShares U.S. Real Estate ETF (IYR)
Let’s take a look at the April options chain for IYR 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 107 calls, with an 77.85% 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 IYR stays below the 107 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 107 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 5-strike, 107/112 bear call spread.
The Trade: 107/112 Bear Call Spread
Sell to open IYR April 14, 2022 107 strike
Buy to open IYR April 14, 2022 112 strike for a total net credit of roughly $0.72 or $72 per bear call spread.
- Probability of Success: 77.85%
- Total net credit: $0.72, or $72 per bear call spread
- Total risk per spread: $4.28, or $428 per bear call spread
- Max Potential Return: 16.8%
As long as IYR stays below our 107 strike at expiration in 37 days, I have the potential to make 16.8% 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 $0.72, I want to buy it back when the price of my spread hits roughly $0.35 to $0.20.
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.
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 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 107/112 bear call spread for $0.72. As a result, if my spread reaches $1.44 to $2.16 I will exit the trade.
There are numerous other strategies we could implement like an iron condor, jade lizard or numerous ratio spreads, etc., but I want to keep it very simple. With IV at historical levels, keeping it simple is the key. And I would argue that’s the case 90% of the time.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Weekly Newsletter for weekly education, research and trade ideas.