How to use Implied Volatility to Trade Short Puts

Today I want to discuss how to use implied volatility to trade a Short Put Strategy. If you are bullish on a liquid underlying with high implied volatility you may want to consider selling short put options to earn income and support your directional bias.

When selling a short put option, the goal is typically to generate income by collecting the premium while hoping the price of the underlying asset remains above the strike price through expiration. To choose a specific short put option, follow these steps:

1. Identify the underlying asset

 Determine which asset you want to trade options on, such as a stock or an exchange-traded fund (ETF). Be sure to use only highly liquid underlyings.

2. Evaluate the option chain

 Review the available put options for the chosen underlying asset. An option chain provides a list of different strike prices and expiration dates.

3. Assess implied volatility  

Look at the implied volatility for each option in the option chain. Generally, higher implied volatility translates to higher option premiums, as it suggests a greater expectation of price movement. However, higher implied volatility also indicates increased risk.

4. Consider your risk tolerance  

Assess your risk tolerance and trading objectives. If you have a higher risk tolerance and seek potentially higher premiums, you may consider short put options with higher implied volatility. On the other hand, if you prefer more conservative strategies with lower risk, you might opt for short put options with lower implied volatility.

5. Compare premiums 

Alongside implied volatility, compare the premiums of different short put options. The premium represents the price you receive for selling the option. A higher premium corresponds to increased income potential but may also suggest greater risk.

6. Analyze the option’s breakeven point

Determine the breakeven point for each short put option. The breakeven point is the underlying asset’s price at which the option trade becomes profitable or neutral. Analyzing the breakeven point can help you assess the probability of the underlying asset falling below the strike price.

7. Evaluate the risk-reward ratio

Consider the risk-reward ratio of each short put option. Assess the potential profit compared to the potential loss if the trade goes against you. A higher risk-reward ratio indicates a potentially more favorable trade.

The Bottom Line

By considering these factors and analyzing implied volatility, you can choose a specific short put option that aligns with your risk tolerance, trading objectives, and market expectations. Remember to conduct thorough research, understand the risks involved, and consider consulting with a financial professional or advisor before making any trading decisions.

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