Options trading basics teaches us that the VIX or CBOE Volatility Index demonstrates the market’s expectation of 30-day volatility. It measures market risk and is also known as the investor fear gauge. With this in mind, covered call writers are faced with a dilemma. Increased market volatility will translate into higher option premiums because the time value component of the premium is directly related to volatility. On the other hand, a high overall market volatility increases our risk as share value can plummet and erase our initial gains. So is a higher VIX a positive or a negative?
One question that is frequently posed to me is that if the VIX is low do we stop selling calls because of lower premiums? This implies that a high VIX is a positive for covered call writers. Let’s take a look at an extreme example in 2008 when the VIX went from the 20 – 30 level to the 70 – 80 level in the last 4 months of the year:
As a general rule, the VIX and the performance of the overall market (S&P 500) are inversely related as demonstrated in the chart below where the market takes a dive in the last 4 months of the year:
To confirm this relationship, let’s look at a comparison chart of the VIX and the S&P 500 since the decline in 2008. In the chart below, note how the VIX has been declining while the overall market has been accelerating. Whenever there was a short-term spike up in the VIX, there was a corresponding decline in the market performance:
This past week
With the markets reflecting huge price swings this past week, we would expect a rise in the VIX and an inverse movement of the S&P 500. Here is the comparison chart as of 10 AM ET on April 11th, 2014:
VIX and covered call writing:
Covered call writing is a conservative strategy and those who use it are generally conservative investors looking to generate cash flow with capital preservation in mind. As such, a high VIX is no friend of covered call writers although we can use our common sense principles to manage those scenarios. A low VIX (under 20) is usually a positive for us because it means a more stable market and oftentimes a rising market as we have experienced since early 2009.
How to manage a high VIX:
We can “stay in the game” by selling in-the-money strikes, using options with lower implied volatility (set goals at 1 – 3% instead of 2 – 4%) and use low beta stocks from our premium reports and ETFs.
How to manage a low VIX:
This is one of the factors that will give us the confidence to take a more bullish stance and sell at-the-money and out-of-the-money strikes with higher beta stocks and higher implied volatility options.
The exit strategies selected in these environments are detailed in my books and DVD Programs.
The VIX is a factor that should be considered in our covered call writing decisions. It should neither be feared nor embraced but rather managed using the fundamental, technical and common sense principles of the BCI methodology.
Amazon sale of my latest book, Stock Investing For Students
I have been informed that Amazon.com will be running a sale on the kindle version of my 4th book, Stock Investing For Students. The price is being reduced from $9.99 to $2.99 for a limited time frame from 4-14 to 4-20-14. Here is the Amazon.com link:
In the brief amount of time since the book was published, I am humbled to report that it has become required reading for finance students at The University of Maryland and will be the basis of an online college credit course later this year through an international broker-dealer. Thanks so much for your support and for helping to make the launching of this book so successful. For more information about the book or to order the paper-version:
Next live webinar: eMoney Show
Tuesday April 22nd
3:20 – 4:20 PM EDT
Place: your computer
This week’s decline in the markets was highlighted by concerns over low inflation which may reflect weak economic growth throughout the globe:
- Minutes from the March 18-19 FOMC meeting suggested that the Fed will not be raising short-term interest rates in the near future despite the Central Bank’s lowering of its bond-buying program by $10 billion per month
- Initial jobless claims for the week ending April 5th came in at 300,000, lower than the 320,000 predicted by analysts
- Revolving credit (like credit cards) dropped by $2.4 billion in February mainly due to the harsh weather conditions
- Non-revolving credit (cars, student loans) however, rose by $19 billion in February
- The total rate for consumer credit (A report of the dollar value of consumer debt, including categories such as credit card use and store charge accounts -known as revolving debt- as well as longer-term loans for autos, education, recreation vehicles – known as nonrevolving debt. The level of consumer credit is considered a barometer of consumers’ financial health and an indicator of potential spending patterns) came in at $16.5 billion higher than the $14.1 billion expected;. This represents an annualized rate of 6.4%
- According to the Labor Department, the Producer Price Index (a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) increased by 0.5%, much more than the projected 0.1%. The year-over-year reading, however, came in at 1.4% price growth
For the week, the S&P 500 declined by 2.6%, for a year-to-date return of (-)1.2%, including dividends.
IBD: Market in correction
BCI: This site maintains a cautiously bullish outlook on our overall economy but is taking a defensive posture as market volatility has increased (still below levels of extreme concern). As a result, we are favoring in-the-money strikes 2-to-1 until that volatility subsides.
Here’s to a better week ahead,
Alan and ther BCI team ([email protected])