Implied volatility (IV) is directly related to the value of the premiums we receive when selling covered call and put options. The more volatile the underlying security, the greater the premium and risk exposure. I have written quite a bit about IV over the years and distinguished it from historical volatility (HV). This article will focus in on implied volatility as it relates to the expected price movement of a stock or exchange-traded fund (ETF) during the life of our sold option contract.
Definitions
Historical volatility is the actual price fluctuation as observed over a specific time frame. More specifically, it is the annualized standard deviation of past stock price movements.
Implied volatility is a forecast or market opinion of the underlying security’s volatility as implied by the option’s prices in the current market.
For short-term option sellers like us, current information (IV) is much more important than historical data which may be more appropriate for longer-term investors.
Implied volatility and our ETF Reports
Many retail investors feel that exchange-traded funds are all low-risk investments because they consist of a basket of stocks, some moving up in price and some moving down and so the security as a whole will be less risky than a single stock. This is true in general but not in all cases. As a result, we provide IV stats in our ETF Reports on pages 7 and 8:
Implied Volatility Stats for ETFs
At the time this report was crafted, the S&P 500 had an IV of 9.74 (yellow field) while the ETF ASHR (top of list) had an IV of 27.44, nearly triple that of the overall market. This means more premium but greater exposure to the downside.
Underlying parameters for IV calculations
Most IV stats are based on projected price movement of the security over the next one year based on 1 standard deviation. So how does this relate to our sale of a (say) 1-month contract? How do we project the expected price movement during our contract obligation? If a stock shows an IV of 30%, it does not mean that it is likely to move 30% in either direction during the contract month because IV is an annual statistic. This is the key takeaway to understand. Furthermore, since IV stats are based on 1 standard deviation, we can expect the accuracy of the price range to be correct 68% of the time. The math is not critical as much as understanding the limitations of IV stats but I’m going to give you a hypothetical example just to be thorough.
Implied Volatility/Standard Deviation Formula
Let’s start with a potential incorrect interpretation of IV stats. Let’s say stock BCI is trading at $300.00 and shows an IV of 30%. Some may decipher that to mean that BCI will trade between $210.00 and $390.00 during the life of our monthly contract. A correct translation is that there is a 68% chance BCI will trade between $210.00 and $390.00 over the next 1 year. The formula to convert this information to a specific contract at a specific point in time:
(Stock price) x (Annualized Implied Volatility) x (Square Root of [days to expiration/365]) = 1 standard deviation
In the hypothetical above with 20-days remaining until expiration, the formula results would calculate to:
$300 x 30% x SQRT (20/365) = $21.07
This means that there is a 68% chance that BCI will trade between $278.93 and $321.07 through contract expiration (not between $210 and $390)
***It is not necessary to memorize or even utilize this formula but it is essential to understand the time frame and limitations of IV statistics.
Discussion
Implied volatility stats are generally framed in annual projections and based on 1 standard deviation. To calculate projected price movement during the life of a contract, a formula can be utilized which will identify a 68% chance of that more restricted range.
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Good morning Alan,
My name is FRANCESCO GUERINI, Italian BCI Premium member living in the United Arab Emirates.
After a few months on your books and DVDs which I thoroughly enjoyed, I finally started paper trading and everything starts making sense and it feels like it is all coming together …slowly the fog dissipates thanks to yours and your team’s expert guidance and mentorship that I believe is second to none.
Thanks for all you have done and continue doing for us regular working Joes all over the world and for our families, leading the way to consistent profits and hopefully financial freedom one day.
You are a truly remarkable leader and mentor!
Kind regards,
FRANCESCO
Upcoming event
February 6th – 9th 2020 Orlando Money Show
BOOTH 306
***********************************************************************************************************************
Market tone data is now located on page 1 of our premium member stock reports.
***********************************************************************************************************************
Hi Alan,
I made a paper trade with GMS which looked good, I thought, on your Weekly Report. When I looked at the November option chain the strike price jumped from ATM $30 to OTM $35. the premium was 1.25 at $30 and very little at $35. I chose the $30.
What caused that difference in strike choices? I went ahead and placed the trade even though it was past 3pm. Would you tell me what you think of my GMS trade.
Another question I know you suggested making new trades 2 days or 3days after expiration Friday. What happens if you go past that time to trade?
Last question. What are the % changes in the movement of the stock price to trigger unwinding the trade.
I am very happy to finally get started.
Thanks,
Homer
Homer,
The “moneyness” of the strike will depend on current market value. A $30 strike will be OTM if the stock is at $29 but ITM if the stock trades at $31.
Right now you have between a 3.5% and 4% initial 1-month time-value return with the stock $0.31 above the strike. So far, so good.
We use the 20%/10% guidelines for closing the option and a 7% price decline is reasonable for closing the long stock.
Alan
Hi Alan,
Hope you are well. I’ve been following the 20/10 rule for the automatic buy to close (“BTC”) for the contracts. Is there a way I can coordinate this with a trailing stop loss order? Do options traders typically do this in addition to buying back the contracts?
I guess I would have to make sure the buying back of the contract happens first since these are covered positions.
Best Wishes,
Ted
Ted,
After closing the short call when share price declines, one must determine the next best step. One of those choices is selling the stock. I use stock price movement compared to the S&P 500 as a guideline. When using a percentile, 7% v- 10% is reasonable. We are in the process of updating the Ellman Calculator to include a 7% price decline column.
Alan
Alan,
You mention selling the stock at a 7% loss in the Sunday email. But the Daily checkup uses 4%.
Which do you use?
Tom
Tom,
The spreadsheet allows us to enter any stock decline alert we want. That will vary from investor-to-investor. In the screenshot below, I entered a 5% alert.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Thank you Alan. Have a great day.
– Ted
Hey friends,
Looks like a positive market environment with solid earnings rolling in, a slew of them on tap this week, Fed on Wednesday, VIX below 13, indexes sailing along above the MA’s, sentiment gauges rising, what could derail this train :)?. Well there is always something and the bears always sound like the smartest guys in the room :)!. Trade deal not done, Brexit, the usual suspects….
I think this is both a great time to be overwriting positions and a great time to have some dry powder (cash) on hand. The last two times we were in this neighborhood we were handed 5% ish pullbacks. Those were great chances to either sell further OTM csp’s or add stocks, let them run a bit then cover.
Will this time be different? Always that chance. But a rate cut would bust the all time highs again. My small speculative option spreads for Friday expiry – I do those for hobby challenge and hopefully discretionary fun money with tiny risk – are all long for this week. Seasonality is good, earnings trend is solid, Fed has been more friend than foe lately so we shall see?
Wishing everyone a successful new week! – Jay
Hey Jay;
If the Fed surprises by not cutting rates this week, then we are probably staring into a 5%ish pull back.
Best;
Terry
I am 100% invested for the 11/15 options cycle, and crossing my fingers.
Roni
Thanks as always Terry and Roni!
You are right, Terry, the Fed holds the cards and the market will react. I placed a few bull bets this week net buying calls. It does not change my base strategy to sell options for premium. But anyone who has ever felt the sting of lost opportunity being left at the bus stop with a meager premium while a stock takes off and drives away knows there is also a place in our arsenal of weapons for buying calls and puts on occasion too. Just sell a lot more than you buy :)!
Nice start to the week as I type this but “Turn Around Tuesday” is always out there for better and worse! – Jay
Jay,
It was several years before I have finally overcome the “sting” of lost opportunity, and to realize that a 2% return in one month is not a meager premium.
But I know what you mean 🙂
Roni
Thanks Roni,
I appreciate your kind forgiveness of my poor choice of words :)!
I am often perfectly happy with “meager” 1% monthly returns on conservative OTM csp’s as a great place to park cash under the market when things get dicey and put premiums increase.Try getting that at the bank 🙂 – Jay
Jay,
I love you, always.
Alan,
I subscribe to your weekly newsletter and have a question that I’ve never seen addressed or I missed it if it was discussed. I recently purchased InMode Ltd (INMD). I want to sell covered calls but no options appear to be available. Most of the stocks I have purchased in the past all have options available for trading. Is there a particular reason why this one doesn’t. Would you know why this would be? Thanks in advance for your help.
Best Regards,
Dave
Dave,
I have been a presenter on behalf of the Options Industry Council over the past several years and have asked this question to those who have intimate knowledge of how these decisions are made. Their response is “supply and demand” If there was a demand for INMD options, there would be a series of products developed to meet that need.
Every week, more options are added so perhaps INMD options may be in the mix at some point in time.
Alan
Thanks for the quick response. I’ll just keep checking.
Dave
Hey Dave,
This quick comment lacks both context and research but if you like the business INMD is in you might look at their larger competitors for options trades or just buy their stock as an investment. – Jay
Alan,
Regarding the TNA from your book, Complete Encyclopedia- volume 2, pages 216 – 220 you use a leveraged etf with a 6-month itm protective put and sell weekly options. Did you ever test it just to see a 6 month result? Also, if there are assignments during those 26 weeks, what do you think the results might really show?
Thanks,
Gerry
Gerry,
I did not test this strategy over a 6-month time-frame. This is a strategy proposed by one of our sophisticated members. I decided to include it in my book because it was both interesting and had several educational components.
TNA seeks to achieve a (1-day) triple return of a small,-cap bull portfolio. As a result, it is extremely volatile. The strategy seeks a $1 per-share return when selling weekly OTM calls. To receive the $1 premium, we must go slightly, not deep, out-of-the-money. This will require us to face in-the-money strikes at expiration in many of the 26 weeks in the proposed strategy. The will result in cost-to-close additional fees and probably significant costs in many of the weeks. That is simply the nature of highly volatile underlyings.
I don’t know what the final results would be but I can say with confidence that it would not come close to the 6-month 25.9% “ideal world” return. With TNA or similar leveraged ETFs we are bringing volatility, and therefore risk, into a conservative option strategy. For most retail investors, this would not be an appropriate strategy.
Alan
Alan,
Thank you for your detailed response. On the stocks you trade what is the general IV that you end up trading? Looking at the list of options to attain 3-4% it seems that the IV needs to be 35-45?
What’s your take?
Thanks,
Gerry
Gerry,
IV is not necessarily that high for an initial 1-month time-value return goal range of 2% – 4%. Once we decide on the “moneyness” of the strike, we check an option chain for strikes that meet our goals. That selection will result in an option with a certain IV but that decision is based on strategy goals, not on a specific IV.
IV is so important to us because it relates to option premium and portfolio risk but it is not the one and only parameter we focus in on. Keep in mind that IV is an annual stat and based on 1 standard deviation meaning that it is inaccurate 1/3 of the time. So IV is important but only one of many indicators we measure.
Bottom line: Our decisions are based on strategy goals, not on one specific indicator.
Alan
Gerry and Alan,
6 months is such a long,long time.
I can hardly wait 4 weeks for the expiry of my calls.
Roni
Alan,
I just subscribed for a trial month and have been consuming your material as fast as I can.
Great stuff!
From my early look, here are a few questions I came up with:
– after importing the watchlist and looking at the charts, how do you reduce the passing stocks from 25 (or however many there are) to ones you want to take action on?
– I lean towards the CashSecuredPut side of your offerings and currently do a CSP strategy by selling puts when the technicals are on the bottom bollinger or are in oversold from a Stoch-RSI perspective. Do you have any favorite technical you use to determine which PUTs (or calls) are ready for you to pull the trigger for a sell-to-open?
Thanks,
Patrick
Patrick,
1. One of the reasons we offer so much information in our reports is that investors have different priorities (aside for the common goal of making money). Let me first give you a quick solution example: Many of our members focus in on stocks in bold (strongest technical indicators) and those with industry rank of “A” or “B” This will narrow down the # eligible candidates.
Others focus in on dividend-generating stocks, low-cost securities or perhaps strong analyst ratings. We make sure we have appropriate industry diversification and the underlyings return premium that meets our initial time-value return goals (use the Ellman Calculator- multiple tab for this).
The selection process will become second nature over a short time-frame.
2. I look at trend and momentum and as well as volume confirmation. The 4 parameters are exponential moving averages, MACD histogram, the stochastic oscillator and volume. It’s a mosaic of indicators rather than 1 particular indicator that influences my selection decisions. Keep in mind that the eligible stocks (white cells) have elite fundamentals and have passed our common-sense screens (adequate trading volume etc.). All stocks in the white cells are eligible (depending on option liquidity) and the ones in bold have the strongest technical parameters at the time the report was crafted.
Alan
Patrick,
Take your time reading / viewing Alans information. The market will still be there. I spend 4 months working on his methodology and understanding the entry and exit strategies.
I recommend as a start his 2 books ** “Classic Complete Encyclopedia Vol 1” – Entry book for Alan’s methodology) and “Selling Cash Secured Puts” – Covers CSPuts in detail.
I also have found using Google search on his Blog will also answer a lot of questions where you benefit from other users questions and answers.
Gppd luck!
Mario
Hi Alan, I can’t find the premium report for this week. Is it available already?
John
John,
,
Several members of my team are recently home our Orlando seminars, so the new report will be available later this afternoon.
We sent out a notice with the ETF email on Wednesday. The report is almost ready as we double check all stats.
Alan
Alan,
My question? I bought BAC for $27.50 and I also sold the call option for the same strike price and I wanted to exit the position which is due November 1st.
Today, how much would it cost me to exit? And how does one calculate it without the Ellman calculator. I don’t mind becoming a member to get the price regularly. I video of the answer would be nice but I’m Good with a written answer.
I own 800 shares.
Thanks,
Ever
Ever,
The after-market price to buy back the $27.50 strike is $4.45 with the closing price at $31.84. We must deduct the intrinsic-value component of the premium and divide by the $27.50 strike to get the time-value cost-to-close:
[($4.45 – ($31.84 – $27.50)]/$27.50 =$0.11/$27.50 = 0.4%
The time-value cost-to-close is $11.00 per contract or 4 tenths of 1%.
We use the “Unwind Now” tab of the Elite version of the Ellman Calculator to do this math for us.
Alan
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 10/25/19.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/
Best,
Barry and The Blue Collar Investor Team
[email protected]
Premium members:
For those of you who, like me, print out sections of our weekly stock reports:
Print out the section of eligible and “removed” stocks” in
landscape” mode rather than “portrait” mode. This will result in larger print easier to read. In this week’s report that would be pages 15-17.
Alan
hi Alan,
i would like to ask a pretty short but really burning question for me.
If followed all steps according to the file EXECUTING COVERED CALL TRADES and if it happens that your contract (1 or more) is not being bought at all?
How long does it take to see if the contract has been bought, please?
Thank you.
P.S. If the last trading day is #3 Thursday of each month, when is the perfect day to buy new stock (following Friday or Monday, please)? What hours?
Thank you,
Julia
Julia,
Once we sell a covered call option, that option can be closed (buy-to-close) BY US, exercised BY THE OPTION BUYER or expires worthless if the strike is higher than market value at expiration.
Exercise can occur up to 90 minutes after 4 PM ET on expiration Friday and, if it occurs, we will see our shares sold on the Saturday after expiration Friday in our brokerage accounts.
The best time to enter a new covered call trade is early in the week after expiration Friday, generally Monday or Tuesday between the hours of 11 AM ET and 3 PM ET to avoid early and late institutional computerized trading.
Alan
Hi Alan,
I just started with the following 3 ETFs I bought today –
ITB @ 44.87$
Sold CC 15th November 45.50 for 42$
VNQ @ 94.22$
Sold CC 15th November 95 for 54$
XLU @ 63.20$
Sold CC 15th November 63.50 for 46$
Total Capital at risk – 20,229$
Return in 15 days(premium collected) – 142$
I sold most of the CC for almost ATM, if I got too much OTM, the premiums are very low. But I do risk the ETFs being called away.
Is this the right approach, any advise ?
Thanks,
Harsh
Harsh,
Your return without any upside share appreciation for the 15 days is 0.7%, 17% annualized. If this meets our goal (looks reasonable to me), then these trades are appropriate.
If the strike(s) is in-the-money at expiration we can either roll the option or “allow” assignment. If shares are sold and there are no negative tax issues, our trade goals are met and we move on to other underlyings.
In general, it is best to enter monthly trades at the start of a contract month before Theta starts eroding the time-value of our options.
Keep up the good work.
Alan
Hi Alan,
Thanks. I’m using the Daily Covered Call Checkup sheet and following the 20/10 rule to manage it. Really great thing! It helps a lot.
I’ll look at entering trade at the start of contract month. I’m going all the material you have on the site, there is lot of information to digest 🙂
Yes I’m trying to target 1-2% per month using only ETFs. I’m wondering if you have a video done for something focused only using ETF portfolio.
I would like to first sell cash secured put and then if the ETF gets assigned, I start selling covered call on it. I want to do it on tickers like SPY, DIA, QQQ, IWM, SMH (Risk On) and TLT, GLD, VNQ, XLP, XLU (Risk Off)
If I fund my account with 75-80K, I think its doable.
Also I’m not sure if selling premium on low beta ETFs is a good idea – as the IV rank is also, so you need to sell almost NTM or a little OTM to generate decent premium. IV seems a big factor for premium generation, Any thoughts on that?
Thanks,
Harsh
Harsh,
I always include ETF information in my books and DVD programs. For premium members, there are also “Ask Alan” videos and webinars relating to this topic on the member site.
You are correct that (generally) ETFs have lower IV than individual stocks and therefore have lower premiums (and risk). IV is THE factor in premium generation. I use these in my mother’s portfolio.
Alan
Alan,
I’ve been using your BCI methodology for selling cash-secured PUTs (CSP) and have a couple questions regarding your CSP flowchart.
First, the guideline of a 3% decline below the strike in the underlying as a trigger for evaluating buying back the CSP seems to be based on the average of the 2% to 4% range of the BCI ROO goal for stocks. If the actual ROO for a particular option is 2%, as an example, wouldn’t it be better to use 2% for the trigger? And isn’t that actually the breakeven point? Also, should the time to expiration be a factor in the trigger or evaluation (maybe more likely to exit the option if early in the period)?
Second, for ETFs like SPY (or to a lesser extent any sector ETF) that represents the market, how can a comparison be made of under or over performing the market? Does that imply that you should stay with the option no matter how far the ETF falls as long as you feel the market will (at least mostly) recover by expiration day? Is that too big of a gamble? Again, would time to expiration be a factor?
Thanks,
Dwight
Dwight,
The book bases the exit strategies on a 2% – 4% initial time-value return goal range. This will vary from investor-to-investor. This is why I refer to this exit strategy as the 3% GUIDELINE. It can be adjusted based on the strategy goals.
If following this guideline, we will not be precisely at the breakeven because we will be paying a time-value component to the premium we pay to close the short put. There will be a small loss but [protect us from substantial losses.
The purpose of this guideline is to mitigate losses on an under-performer so it should be implemented early or late in the contract.
Comparing the price performance of an ETF (or stock) to the S&P 500 is one of the parameters we use. We always have the choice to sell the underlying (CDMCP in my books and DVDs). This and the 20%/10% guidelines are for covered call writing and the 3 % guideline is for CSPs.
Alan
Hi Alan,
Excellent article.
You posted a related article, “Volatility Skew- Understanding Option Premiums Over Different Time Frames and Strikes” on October 20,2012. In the archives the charts in that article do not show up, at least in my browser.
That article was also excellent and, in my humble opinion, deserving of reposting with the now missing charts.
Thanks for all you do.
Hoyt
Hoyt,
I have asked my team to look into this matter… thanks for the heads-up.
Alan
Premium members:
This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.
Also included is the mid-week market tone at the end of the report.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
Money Answers Radio Show:
I have accepted an invitation to be interviewed on this program on Monday December 2nd at 3 PM ET – 4 PM ET. I’ll provide more information as I receive it.
Alan
Alan,
I entered a trade for TJX on 10/15/19.
I bought the shares on 10/15 for $58.60
I sold an 11/15/19 covered call with a strike price of $57.50 (ITM) for $2.08 / contract.
The newest report dated 10/25 now shows that the stock did not pass the screen.
Shares as of 1:40 p.m. today are trading at $58.07
MACD has turned downward but Stochastics are approaching oversold.
I will keep an eye on it but would like some insight on the stock screening, particularly what to do when this situation arises.
– Ted
Ted,
Once a trade is entered, we manage it as set forth in my books and DVDs, not based on its removal from our premium watch lists. If we sell a stock and need a replacement, it is selected from our most recent report.
In this case, we still have a maximum return unless TJX moves below the $57.50 strike. We use our 20%/10% guidelines to assist us in when to close the short calls. There are many times when no action is indicated.
Alan
Understood. Thanks Alan.
– Ted