When we write covered calls or cash-secured puts, we are selling volatility. The time value component of a short-term option premium reflects the amount of time until expiration plus the volatility of the underlying security. Since most of us are comparing options with similar expirations, the volatility of the stock or exchange-traded fund represents the distinguishing factor in our option sales. In this article, we will review all aspects of volatility and bring this information into our world of option-selling.
What is volatility?
Volatility represents the price movement of the underlying security with no predilection to direction. It is an annualized statistic quantified as one standard deviation price change. This tells us that the statistic is projected to be accurate 68% of the time. This means that if a $60.00 stock has a volatility of 25%, it is expected to fall in the price range of $45.00 to $75.00 over one year 68% of the time. Two stocks that start and end with the same price over a one-year time frame can have very different volatilities as shown in the chart below:
Although both securities started and ended the year at $100.00, the “blue” stock has much greater volatility and will generate higher option premiums at the expense of being a riskier underlying security. Each investor must determine the amount of volatility appropriate for their personal risk tolerance. For me, I have a goal of 2 -4% for a near-the-money one month expiration. In bull markets, I’ll go a bit higher. The question we should ask ourselves is “how much volatility should I sell?”
Types of volatility
Historical volatility: The actual price fluctuation as observed over a period of time, usually one year.
Expected volatility: This is a prediction of future price movement in either direction and is totally subjective. This is the least significant of the three types of volatility.
Implied volatility: This is a prediction of the underlying security’s future price movement based on the option’s price in the marketplace. For short-term option-sellers, this is the most significant of the three types of volatility. An event like an upcoming earnings report can render the implied volatility much higher than the security’s historical volatility.
Impact of volatility on our option premiums
An increase in volatility will increase the value of both call and put options and a decrease in volatility will cause a decline in both call and put premiums.
The role of Vega
Vega is the amount an option price will change given a 1% change in implied volatility. Let’s say that company BCI has an option value of $4.00 and a Vega of 0.06. The current value of one contract is $400.00. If the implied volatility increases by 1%, the option value for the contract will be $406.00. If the implied volatility decreases by 2%, the value of the contract will become $388.00, all other factors remaining the same.
Impact of Vega and the “moneyness” of options (for every 1% change in volatility)
In-the-money options: Have the least amount of time value and therefore the smallest dollar and percentage changes.
At-the-money options: Have the greatest time value and the largest dollar changes.
Out-of-the-money options: These are all time value and therefore the highest percentage changes.
Discussion on incorporating volatility into our option-selling strategies
As covered call writers and sellers of cash-secured puts, we are selling volatility. For our short-term positions, implied volatility is the most most significant of the three types of volatility because it reflects the current market assessment of future price movement of our underlying security. A great starting point for incorporating volatility into our trading decisions is to set return goals based on personal risk tolerance. A conservative starting point may be 2-4% per month for near-the-money strikes. Extremely high or low implied volatilities will not meet this standard. Goals can be tweaked based on your objectives and risk tolerance. Once size does not fit all!
Blue Collar Scholar Competition: Great prizes and a worthy charity
We’re trying something new thanks to Jay’s idea. Here are the parameters we are using: Two contests running simultaneously with six prizes:
Contest #1: What will be the value of the S&P 500 by year’s end?
Contest #2: In five sentences or less, give your reason(s) for your response (subjective, voted on by the BCI team)
Prizes in each category (total of 6).
Donation to the USO (United Services Organization) of $5000.00 worth of books.
Contest results to date
% bearish: 8%
% neutral: 41%
% bullish: 51%
Sample Commentary from Arturo S:
Because in a 100 day chart there was a “W” formation and it hit that amount 3 times already. Knowing it’s about the end of the year, people will be cashing in on this bullish scenario.
Thanks for the great response we’ve had to this event. Keep those entry forms coming. We allow two per email address and the deadline is November 30th.
I’ve been remiss in not saying this in a while
A special thanks from me the entire BCI team to our premium subscribers for making these reports and tools a success beyond our wildest dreams.
Next live appearance
American Association of Individual Investors National Conference
Las Vegas, Nevada
November 7th – November 9th
Sunday November 8th @ 8:30 AM – 9:45 AM (Alan’s seminar in Bronze Room)
Exhibit Hall # 313
***Event is sold out
Major global stock markets were neutral this week on mixed economic data. Growth in Europe offset weakness in China, while US data was generally bullish especially Friday’s jobs report. Asian stocks rose, with the Shanghai Composite Index gaining 20% since its August low, signifying a bull market. This week’s reports:
- US nonfarm payrolls grew by 271,000 in October, exceeding the median consensus of 180,000
- The unemployment rate fell to 5.0%, the lowest since April 2008
- Average hourly earnings rose by 0.4% from September and were 2.5% higher than a year earlier. It was the highest year-over-year wage increase since 2008
- The U-6 rate, which measures underemployment fell to 9.8%, a seven-year low. After the stellar payrolls report and comments by US Federal Reserve Chair Janet Yellen on Wednesday, a December rate hike is now more probable
- The US trade gap narrowed to a seven-month low in September as US oil imports fell to their lowest level in more than 11 years. The deficit narrowed to $40.8 billion in September from $48 billion in August
- US light vehicle sales increased 13.6% in October from a year earlier. For a second consecutive month, the annualized sales pace exceeded 18 million, the best two-month stretch in 15 years. The auto market is on pace for its strongest annual results ever
The Institute for Supply Management’s non-manufacturing index rose to 59.1 in October from 56.9 in September. The US service sector has expanded for 69 straight months
- The ISM manufacturing index fell from 50.2 in September to 50.1 in October, the weakest reading since May 2013
- US labor productivity unexpectedly rose at a 1.6% annualized rate in the third quarter
- Initial jobless claims increased 16,000 to 276,000 for the week ending October 31st
- Continuing claims increased 17,000 to 2.16 million for the week ending October 24th
For the week, the S&P 500 rose by 0.95% for a year to date return of 1.96%.
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of October 19, 2015
BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes. I will remain cautious but fully invested until after the December Fed meeting.
Wishing you the best in investing,
Alan ([email protected])