Covered call writing generates monthly cash flow by selling short-term options. The main factor in determining the amount of this premium is the implied volatility (IV) of the underlying security. The effect that IV has on the premium is known as vega, one of the option Greeks.
What is vega?
Vega is the expected change in the value of an option with a 1% change in implied volatility whether up or down. It is expressed in decimal form (.040) and represents cash amount per share. As with the other Greeks, it is based on all other pricing factors remaining the same. Calls and puts both have positive vega amounts so that if implied volatility increases the option value on both will rise by the vega amount. If implied volatility decreases the option value will fall by the vega amount. A change in implied volatility or vega does not require an associated change in stock price. Vega has its greatest dollar impact on at-the-money strikes and its greatest percentage impact on out-of-the-money strikes. Also, the greater the time to expiration, the higher the vega.
A stock’s implied volatility can vary dramatically from its historical volatility (actual price fluctuation as observed over a period of time. Also known as statistical volatility). It can also change quickly and dramatically and is considered the most significant price factor in option value. In addition, implied volatility is rarely the same through the various strike prices and expiration dates as shown in the figure below:
The red line separates strikes prices for GLOG, a stock currently on our Premium Watch List, May and June expirations. Note how the IV differs from strike to strike and between expiration dates as well.
Using vega when selling covered calls
We know that vega is mainly impacted by implied volatility and the higher the vega, the higher option premium, all other pricing factors remaining constant. We also know that the greater the implied volatility, the higher the risk. We can use this knowledge to tailor our trading to our personal risk tolerance and overall market assessment. My goal for initial, 1-month returns is 2-4% per month. More aggressive investors will set higher goals and vice-versa. Another factor to consider is that implied volatility rises prior to news announcements and therefore will enhance our risk exposure. That is why we avoid selling covered calls prior to earnings announcements.
When to consider options with high vegas
• Higher personal risk tolerance
• Bullish market outlook
• Strong and confirming chart technicals
When to favor options with low vegas
• Low personal risk tolerance
• Bearish or volatile market outlook
• Chart technical mixed
This assessment and determination can be accomplished without looking up the vega stats for every option on every stock although many brokerages provide options chains that incorporate much of this information. I make my investment decisions in a quick and user-friendly manner. I set a goal based on initial option premium return (time value only). My goal as stated above is 2-4% per month for these initial option returns. I have found over the years that adhering closely to this parameter will allow me to generate favorable monthly returns and minimize the risk of higher-vega options. In strong bull markets I may get a bit more aggressive and set higher monthly goals and in strong bear markets I may set lower monthly goals.
Call vega example
• BCI call option has a value of $4 and a vega of 0.06
• Current contract value = $400
• Implied volatility increases by 1%
• The new contract value would be $406, a gain of $6
• If implied volatility decreases by 2%, the contract value would decline to $388 (400 – $12)
Our option premium amounts are impacted mostly by the implied volatility of the underlying security. The impact that IV has on the option value is measured by the Greek known as vega. We can tailor our covered call writing plan to meet our personal risk tolerance needs and overall market assessment by factoring in vega as a key determining factor.
For detailed information on all the Greeks
See pages 156 – 166 in the Complete Encyclopedia for Covered Call Writing.
Attention members from Australia
One of our members from Australia, Ryan, would like to connect with you to discuss trading covered calls from outside the US. If you would like to assist Ryan with his questions, please contact me (email@example.com) and I will provide you with his contact information.
Attention members from Spain (this week’s blog has an international flavor to it!)
Last week there was an issue with Spain’s main internet provider, Telefonica Movistar, and our members could not access our site. I would like to send my sincere thanks to Rogelio and Carlos for speaking with the provider and getting this matter resolved.
Financial literacy quiz question
Would you rather have $1 million or a penny a day for a month? Answer at bottom of blog.
Disappointing news regarding home-sales data overshadowed an otherwise positive week of economic reports and earnings results:
- Sales of existing homes dropped by 0.2% in March, below expectations and 7.5% below sales from a year ago. Analysts ascribe these stats to higher borrowing and home costs as well as severe weather conditions. However, sales in February and March fell less than in the previous months
- The median sale price for existing homes in March came in at $198,500, 7.9% higher than a year ago
- New single-family home sales in March fell by 14.5%, lower than projected by analysts and 13.3% lower than a year ago
- In March, the median sale price for a new home came in @ $289,800, the first increase after 3 straight monthly declines
- The Conference Board’s index of leading economic indicators (a composite index of ten economic indicators that typically lead overall economic activity. The index includes indicators such as housing permits, new orders for consumer goods, consumer expectations, and performance of the S&P 500 Index) rose by 0.8%, better than the 0.7% expected. This was the 3rd straight increase and 10th in the past 12 months
- Durable goods orders in March accelerated by 2.6%, better than the 2.0% expected by economists. This was the second month in a row of increases
For the week, the S&P 500 was down 0.1% for a year-to-date return of 1.4%, including dividends.
IBD: Market in correction
BCI: This site remains moderately bullish on the overall economy but staying in a defensive posture until the geo-political and global economic concerns subside. We are favoring in-the-money strikes 2-to-1.
Wishing you the best in investing,
I often speak about the power of compounding and this answer highlights that turning down the instant $1 million would make the most sense. In a 31-day month, doubling a penny every day yields close to $11 million. Now if we can only find those 100% return investments!
My best to all,