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We might say that we got lucky on our SPY trades. But how lucky? Did we beat the odds? Or did the odds favor us? How can we tell? Can we explain our good fortune? Well, we can try.
Let’s begin by looking at the price chart for SPY.

The chart above tracks the daily movement of SPY going back one year. The horizontal line marks our 426 strike on our trades. The solid vertical line marks the day we entered our trades. Notice the change in the pricing behavior that occurs in late April. Prior to late April, whenever SPY hit around the 426 level, it bounced back up. But after a decisive break of that level it struggled to regain it. The 426 level is an example of an area of support that once broken became a level of resistance. Some might ask what changed with SPY. A better question might be what changed with investors who had become unwilling to drive prices higher across the broad spectrum of stocks that make up the S&P 500. The likely answer is their rising concern about inflation and recession fears as well as worrisome international news about war in Europe and exacerbation of supply shortages in many areas that had been coalescing. A few days before our trade, the 426 level of resistance was finally tested. SPY briefly broke above 426, but notice that throughout its rise volume had been decreasing. Fewer and fewer investors believed in its climb. See how volume changes as SPY falls decisively in the few days prior to our trade. It seems as if the market had decided, at least for the time being, that SPY will go no higher than about 426. Beyond the level of resistance, we can also look at SPY’s volatility; that is, how much its price varies up and down over time.
We should look at two different kinds of volatility: historic (or realized) volatility and implied volatility. Historic volatility is how much the price of an issue has varied in the past. Implied volatility is how much investors think the price of an issue will vary in the future. Calculating historic volatility is straight forward. I’m not going to delve into the math, but determining the standard deviation of the highs and lows is where the calculation begins. Implied volatility is trickier because it purports to predict the future.
To calculate implied volatility, we turn to the pricing model that is used for options. For a more complete description of a widely used model, look at the Black-Shoals model on Wikipedia. The model, and derivatives of it, explain option pricing as a function of the price of the underlying asset, the strike price of the option, the time until expiration of the option, the risk-free interest rate, and (the unknown) implied volatility. In practice, the market determines the price of the option, so the only unknown is volatility, which can be derived through algebraic manipulation. In other words, implied volatility is a crowd-sourced value determined by the aggregated opinion of the relevant traders. When implied volatility increases, the price of an option increases. An interesting feature of implied volatility is that it is usually, though not always, higher than realized volatility, which suggests that options tend to be over-priced. In future posts we can examine why this is the case. For now, though, we can make practical use of this phenomenon by selling options where implied volatility exceeds historic volatility. The discrepancy between implied volatility and historic volatility is sometimes referred to as the volatility risk premium, a moniker that suggests the similarity between buying options and buying insurance. Both of the features we have so far discussed have focused on the opinion of those who were trading; the final feature we’ll consider is the volume of trades.
We briefly mentioned the role of volume earlier when discussing underlying price. In options, volume may be even more important. If many traders express an opinion on pricing by entering trades, we can have greater certainty in the validity of their opinions. The measure best used for this is open interest; that is, the number of contracts that are open. As I write this, 4963 contracts are open for the September 2, 426 strike. Since each contract represents two traders (the buyer and the seller), the pricing represents a 9926 instances where individual traders found agreement on pricing. The effect of this significantly large number is twofold: first, the interest level means that we should have little trouble finding someone to trade with us when we open and when we close the contract, and second, the bid-ask spread will be narrow. Spreads on SPY tend to be only one or two cents.
Key take-way: A trader’s success depends on what other traders are thinking and doing.