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How To Use Volatility in Selecting Covered Call Trades

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.

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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.  

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.

How To Trade The Calendar Spread for Income

A calendar spread, which is often referred to as a time spread, is the buying and selling of a call option or the buying and selling of a put option of the same strike price but different expiration months.  In essence, you are selling a short-dated option and buying a longer-dated option.  This means that the result is a net debit to the account.  In fact, the sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright.  Because the two options expire in different months, this trade can take on many different forms as expiration months pass.

There are two types of long calendar spreads: call and put.  There are inherent advantages to trading a put calendar over a call calendar, but both are readily acceptable trades.  Whether you use calls or puts depends on your sentiment of the underlying investment vehicle.  If you are bullish, you would buy a calendar call spread.  If you are bearish, you would buy a calendar put spread.

A long calendar spread is a good strategy to use when you expect prices to expire at the value of the strike price you are trading at the expiry of the front-month option.  This strategy is ideal for a trader whose short-term sentiment is neutral.  Ideally, the short-dated option will expire out of the money.  Once this happens, the trader is left with a long option position.

If the trader still has a neutral forecast, he or she can choose to sell another option against the long position, legging into another spread.  On the other hand, if the trader now feels the stock will start to move in the direction of the longer-term forecast, he or she can leave the long position in play and reap the benefits of having unlimited profit potential.

How to Find Calendar Spread Candidates

 • Check the current value of implied volatility (IV) and the history of IV over the past three to six months (free at ivolatlity.com).  Be sure the current IV is in the bottom quartile of recent IV history.

• Don’t trade a negative IV skew (if ≤ 2 points, maybe… but doubtful).

• Investigate very carefully if the positive IV skew is ≥ 4 points (suggests a big move is expected).

• Calculate the standard deviation (σ) for the candidate stock; use current IV and number of days to expiration of the front month option; look at the price range (lowest to highest) of the past week and the past month; avoid this stock if the recent price ranges are > 1 σ.

• Be sure no earnings announcements or other significant announcements are pending during the course of the proposed trade.

• Be sure you are selling > $0.40 of option premium (otherwise, commissions eat up too much of your profit).

• Calculate the breakevens (BE) using your trading software; you want a broad range between the BEs.

• Low IV stocks (12–‐20%) are conservative but require a large number of contracts; consider the effect of commissions.  Stocks with higher IVs (≥ 20%) present more price movement risk but have large premiums

Managing the Trade – Making Trade Adjustments

 • When you have traded calendar spreads for at least 6 months, you may consider adjustments. Until then, simply close the trade when the stock price hits a BE or the trade hits the stop loss you established. 

• Use the BEs or a price just beyond the BEs as your trigger.

• Close a portion of your contracts and place another calendar at or near the new price; determine the number of contracts to close and roll up or down by the number it takes to move your position delta back closer to zero.

• For example, IBM is at $172 and we put on 10 contracts of a $175 call calendar. IBM moves to $176 (our upper BE); we close 4 of our $175 calendars and open 4 $180 call calendars.  If we think IBM may move even higher, we might place the new spreads at $185.

• Don’t adjust a trade if you have < 15 days left to expiration (unless you have multiple months, e.g., you have a Jun Sep $175 call calendar; we close some or all of our Jun $175 calls, and wish to roll up to $180 but we only have 8 days to expiration; then you would sell the July $180 calls).

• Manage the new calendar spread just like the original trade (write down your management criteria).

In summary, it is important to remember that a long calendar spread is a neutral – and in some instances a directional – trading strategy that is used when a trader expects a gradual or sideways movement in the short term and has more direction bias over the life of the longer-dated option.   This trade is constructed by selling a short-dated option and buying a longer-dated option, resulting in a net debit.  This spread can be created with either calls or puts, and therefore can be a bullish or bearish strategy.  The trader wants to see the short-dated option decay at a faster rate than the longer-dated option.  The time decay is your income just like it is in the covered call trade.

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