Trading credit spreads requires a careful approach to generate income and manage risk. Implied volatility rank (IVR) is widely used in options trading. However, it has limitations when applied to credit spreads. In this article, we explore why relying solely on IVR for credit spread trading can be risky and yield suboptimal results.
5 Reasons To Never Use IVR (Implied Volatility Rank)
Incomplete Market Assessment:
IVR measures implied volatility relative to historical volatility. But, it doesn’t provide a full view of market conditions or factors driving volatility. Credit spreads involve analyzing both option volatility and the overall market environment. Relying solely on IVR may lead to incomplete market assessment and misguided trades.
Ignoring Skew and Term Structure:
IVR focuses solely on implied volatility, disregarding skew and term structure in the volatility curve. Credit spreads involve buying and selling options with different strike prices and expiration dates. Neglecting skew and term structure can impact pricing and risk-reward dynamics. Relying only on IVR overlooks these crucial elements, affecting trade profitability and risk management.
Lack of Precision in Entry and Exit Points:
Optimal entry and exit points are crucial for credit spreads. IVR, as a relative measure, doesn’t provide precise guidelines for identifying these points. Solely relying on IVR may result in entering trades at suboptimal levels or exiting prematurely, sacrificing potential profits and increasing risk.
Inadequate Risk Management:
Effective credit spread trading requires robust risk management. IVR provides insight into market expectations, but doesn’t address inherent risks. Depending solely on IVR without considering risk management techniques exposes traders to unexpected losses and limits adaptability. Risk management techniques include position sizing or stop-loss orders.
Potential for Misinterpretation:
Misinterpretation or misuse of IVR can lead to poor trading decisions. Solely relying on IVR without considering other factors may result in overconfidence or ill-informed choices, negatively impacting credit spread trades.
10 Year SJ Options Backtest Proof
Each credit spread sold near the -.10 delta and bought the .-05 delta to complete the vertical. We used the “Let your losers ride” trading method, which was recommend by Tasty Trade. $10,000 was allocated to each product. We compounded returns so that $10,000 was total investment and max risk of each.
- Back Test #1: AAPL 2005 to 2015 (-100%)
- Back Test #2: IWM 2005 to 2015 (-93%)
- Back Test #3: MSFT 2005 to 2015 (-86%)
- Back Test #4: QQQQ 2005 to 2015 (-100%)
- Back Test #5: SPX 2005 to 2015 (-100%)
- Back Test #6: WMT 2005 to 2015 (-74%)
SJ Options acquired and calculated this data.
How I Trade Credit Spreads Without IVR
Instead of relying on IVR, I rely on the Trend to enter credit spread trades. Unlike IVR, the trend has mathematically proved to beat the market over two centuries. This has to do with the fact that trends are created by human psychology (fear and greed), and humans never change. So, until the market is completely traded by robots, trends will work.
The backtests using the trend instead of IVR yields a 60% annualized return. Which as we know, is better than the backtests above. If you are interested in learning more about that or seeing the backtest, check it out here! I would encourage you to implement trend following over IVR.
Thanks for reading 🙂
Austin Bouley
Founder & CEO