Whether we are selling covered calls or cash-secured puts we frequently look to our broker platforms for ways of enhancing our trading success. As these platforms become more sophisticated and competitive, there are a myriad of software analytical programs offered including those geared to probability analysis. A typical program will use implied volatility stats to determine the likelihood of an option strike price ending in- or out-of-the-money. The implied volatility figures are generated from option-pricing models like the Bjerksund-Stensland Model. Now, when we write covered calls, it would be useful to know the likelihood of a stock price dipping below the breakeven. So, the question becomes how beneficial are these programs and should we invest time and effort into them or devote our attention to other areas?
Recently, Miguel sent me an email asking about probability analysis for a successful trade. Since these programs rely so heavily on implied volatility, let’s define implied volatility and distinguish it from historical volatility.
Historical volatility is the actual price fluctuation as observed over a specific time frame. More specifically, it is the annualized standard deviation (discussed below) 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. It is typically based on one standard deviation (accurate 68% of the time) and on an annualized basis. Therefore, if the implied volatility is 25% for a stock trading at $60.00, it is expected to have a price range between $45.00 and $75.00, 68% of the time over the next one year. The higher the implied volatility, the greater the potential trading range and therefore the higher the risk of an unsuccessful trade (moving below the breakeven). The information generates a range, not a direction and those stats are correct 68% of the time, by definition (with the caveat that the number of standard deviations can also be adjusted, but one is most typical a shown in the brown highlighted area below).
What is a successful covered call trade?
In my view, the best way to define a successful trade is one that generates a profit that meets our targeted goal. Some might define it as a trade that makes money. There are different perspectives. I have many friends that define a successful day at the casino as one where they only lost the money they brought…different strokes for different folks.
If we ascribed the chance of a stock price going up or down, we would say the chance is 50/50. Since we are starting of with an option premium and a breakeven below current market value, it is not unreasonable to say our chances of successful covered call trades are greater than 50/50.
80% chance of success
Here are the 5 things that can happen to a stock price:
- Price moves up substantially
- Price moves up a small amount
- Price remains the same
- Price moves down less than the option premium amount
- Price moves down substantially
The first 4 result in a successful trade if we define such a trade as one that makes money. What becomes apparent is that the amount we lose in the fifth scenario is a major factor in our overall strategy success. Maximizing gains and mitigating losses are key elements in our exit strategy arsenal.
Probability analysis and the moneyness of the strike at expiration
The strike ending in-the-money or out-of-the-money can be a positive or a negative depending on strategy goals. For example, if we didn’t want to have a stock sold because of potential tax consequences, it would be helpful to know the probability of ending in-the-money. We may want to move the strike further out-of-the-money depending on our risk-tolerance.
The major missing element in probability analysis
The software programs do not factor in position management. Taking advantage of exit strategy opportunities changes everything and renders probability stats inaccurate. Proactive, non-emotional management of our option-selling trades results in the probability of successful trades so much greater than the non-managed projections of these software programs.
Factors more important then probability analysis
- Stock selection
- Option selection
- Position management
- Overall market assessment
Probability analysis has its place when selling options but, in my humble opinion, it is not a factor we should hang our hats on. By setting an initial return goal based on our personal risk tolerance we can manage our implied volatility risk exposure. The higher the time value initial returns for near-the-money strikes, the greater the risk. I have found my sweet spot to be between 2 – 4% per month for initial returns. I use lower implied volatility securities in my mother’s account where I target 1-2% per month. To sum up, the chances of successful covered call trades are greater than 50%, perhaps as high as 80% but the degree of our losing positions will impact our net final results.
Thanks to Miguel for providing the motivation for this article.
Upcoming live events
1- April 12, 2017
3:30 – 4:30
Income Generation Webinar for the Options Industry Council
2- April 13, 2017
Alan will be interviewed on Benzinga Pre-market Radio Network regarding the best strategies to use in the current market environment.
Information and link (scroll down to bottom of page)
Global stocks were little changed this week despite geopolitical concerns following the US missile strike on a Syrian airbase and a potential shift in tactics by the US Federal Reserve later this year. Oil prices solidified after the attack, with West Texas Intermediate crude rising to $51.94, up from $50 a week ago. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), remained historically low, at 12.87 on Friday versus 12.37 a week ago. This week’s reports and international news of importance:
- US payrolls expanded by 98,000 in March, well below the 180,000 expected
- In addition, both January and February payrolls were downwardly revised
- However, the unemployment rate dipped 0.2% to 4.5%, the lowest level since May 2007, while average hourly earnings rose 2.7% versus a year ago, down from 2.8% in February
- In response to a chemical weapons attack in Syria by the regime of Bashar al-Assad, the United States launched nearly five dozen Tomahawk cruise missiles targeted at the airfield from which the attack is believed to have been launched
- US president Donald Trump and Xi Jinping, China’s president, held talks at Trump’s Mar-a-Lago Club in Palm Beach, Florida. The leaders discussed trade relations between the world’s two largest economies as well as security concerns, particularly over North Korea
- The minutes of Federal Open Market Committee discussed shrinking the Fed’s $4.5 trillion balance sheet beginning late this year by allowing some of the assets it acquired in the wake of the financial crisis to mature. However, the committee did not outline specifically how it will change its reinvestment policy. Those specifics are expected later in 2017
- The eurozone purchasing managers’ index in March rose to its highest level in nearly six years, reaching 56.2 from 55.4. That’s the highest since April of 2011
- European retail sales rose solidly for the second month in a row in February, rising 0.7%
- In the United States, the Institute for Supply Management’s manufacturing index eased to 57.2 in March from February’s 57.7
- Credit rating agencies Standard and Poor’s and Fitch each downgraded South Africa’s sovereign credit rating one level to BB+ in the wake of the sacking of former finance minister Pravin Gordhan. Weakening standards of governance and public finances were to blame
THE WEEK AHEAD
MONDAY, APRIL 10th
- None scheduled
TUESDAY APRIL 11th
- Job openings Feb.
WEDNESDAY, APRIL 12th
- Import price index March
- Federal budget March
THURSDAY, APRIL 13th
- Weekly jobless claims 4/8
- Producer price index Marsh
FRIDAY, APRIL 14th
- Consumer price index March
- Core CPI March
- Retail sales March
- Consumer sentiment April
- Business inventories Feb.
For the week, the S&P 500 moved down by 0.30% for a year-to-date return of 5.21%.
IBD: Uptrend under pressure
GMI: 4/6- Buy signal since market close of November 10, 2016
BCI: I am currently favoring in-the-money strikes 2-to-1
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral to a cautiously bullish outlook. In the past six months, the S&P 500 was up 10% while the VIX (12.87) declined by 5%.
Wishing you the best in investing,
Alan ([email protected]) and the BCI team