If options were always fairly priced, then we would expect the option price to always imply a level of stock volatility that is more or less in line with historic volatility (HV). But this not always the case. For example, two stocks are trading at $20 each with current month calls at $20; one calls ask price is $1.00 while the other is at $2.00. In comparison, one calls value is twice the others. Why? The difference is in implied volatility of the two stocks.
Implied volatility is the market’s perception of how volatile a stock will likely be in the future. A covered call trader must understand how implied volatility affects their trading decisions. IV Can be the same as historical volatility, lower than historical or higher than historical. What if an option has an implied volatility of 70% while the stock had a volatility of 25%? The Black-Scholes calculation would tell us that the option is overpriced.
The key to covered writes: how implied volatility compares to historical volatility. When option volatility (call IV) is lower than the 10-day/30-day historical volatility, then the call option is under priced. For call writers, under priced options mean you are not being paid for the stock’s actual volatility. However, if the calls IV is extremely higher than historical volatility, the market is expecting something to happen. If after the event the IV collapses then the calls value will collapse. But…
You should not chase the high IV because those stocks are too risky. You should compare IV to both the 10-day and 30-day historical volatility. This will tell you if the the IV is in line with HV. Generally, you do not want IV to be significantly higher (10-15%) than either 10-day or 30-day historical volatility.
The rules are as follows:
- If IV is higher than HV – then an event is projected such as news, earnings, etc. Find another stock to write calls on;
- If IV is lower than HV – then the option is likely under priced so you should Find another call write trade;
- If IV is in line with HV – then this is a good trade if stock volatility is below 40%.
For conservative covered calls, you want stock volatility below 40%. Any stock with a volatility above 60% is too risky for a covered call trade.
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