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Options Basics – How to Use Volatility in Covered Call Trades

There are two types of volatility used in security analysis: historical volatility measures the past price movements and implied volatility that indicates the potential level of future volatility a security is implying.

Historical volatility (HV) is the price changes of a security over a period of time so it is really a standard deviation calculation.  This means it is how much a stock price has moved over time usually expressed as a 10-day or 30-day volatility.  For example, a stock with a volatility of 70% is high and should be considered quite volatile.  This is not the type of stock to write a covered call on.  In contrast, a stock with a volatility of 20% is a low volatility stock and selectable for a covered call.

The stock’s volatility can help us forecast short-term price ranges and the relative value for an option price.  The option premiums of highly volatile stocks will have a high value while a low volatility stock will have a much lower premium.  An options premium will be influenced by the probability the stock price will move above or below the various strike prices.  Of course, the excitement of high premiums leads to some investors falling into the premium trap by chasing highly volatile stocks that impose a significant risk to loss of capital.

Another thing to keep in mind is the stock volatility as a confirmation of the stock chart.  Suppose you are looking at a stock chart that seems to be in a trading price range that is stable.  The 30-day historical volatility is 72%.  Is this a good stock candidate for a covered write?  The correct answer is no if you are seeking a conservative covered call investment.  Compare the 72% volatility to a stock with a 30 day HV of 25% which is lower than the S&P 500 at the same time.  I would select the stock with a 25% 30 day volatility for a more conservative covered call investment.

The bottom line is that adding volatiliy to your covered call selection process will increase your chances of morw winning trades and a more consistant income stream.  There will be several more posts about volatility in covered call investing in the coming days.

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