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:
Implied volatility and vega for covered call writing
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)
Summary
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 (alan@thebluecollarinvestor.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.
Market tone:
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.
Summary:
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,
Alan (alan@thebluecollarinvestor.com)
www.thebluecollarinvestor.com
Quiz answer:
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,
Alan (alan@thebluecollarinvestor.com)
www.thebluecollarinvestor.com
Alan,
Where can we get reliable stats on the Greeks and implied volatility.
Thank you.
Paula (met you at your Orlando seminar)
Paula,
A reliable free site:
• http://www.cboe.com
• Tools
• Option calculator
• Enter stock ticker
• “Go”
• Adjust for strike in question
• Calculate
• For implied volatility enter option price in lower right box
Alan
Paula,
I added the screenshot below to my response to show what the results look like. CLICK ON IMAGE TO ENLARGE AND USE THE BACK ARROW TO RETURN TO THIS BLOG.
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 04-25-14.
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 BCI Team
Premium Members:
This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. Look for the report dated 04/25/14-RevA.
The ER date for THRM has changed and is no longer eligible for this month until THRM reports on 5/1/14. We have verified the change on THRM’s website.
Best,
Barry and the BCI Team
I just purchased THRM last week off the Premiun report. Given the ER May 1st, should I now sell the stock?
Tom,
Please see my response to Emily below.
Alan
I have a quick question regarding earnings reports. I sold calls on 2 stocks, THRM and GLOG that have changed their ER dates. The dates now fall before expiration Friday. My question is, should I unwind my positions now for a slight loss and put the cash into other stocks, or should I wait until the day before the ER to unwind my position so that time decay will have decreased the value of the option premium that I need to buy back?
Thank you for your time,
Emily
Hi Emily,
I can tell from your question that you are an elite covered call writer. When a projected ER date changes and you are in a covered call position, it is important to close that position because of the inherent risk in a disappointing ER even at a slight loss. The rare exception is when we feel that there is a very good chance of a positive report, then we just buy back the option and re-sell it after the report passes hopefully after capturing the share appreciation from a positive report. For example, in the 1990s I did this consistently with CSCO because they tended to mute their guidance and therefore positively surprise quarter-after-quarter. I won nearly every time. Apple too, back in the day.
Now about allowing time erosion before closing. You can close anytime prior to the report. The benefit of closing later will be negated by the loss of time value in the new position you enter with the cash generated from the sale of the original stock.
Should we decide to close the short option position and hold the long stock through the ER, then waiting closer to the report date does make sense.
Alan
Thank you for your response. I will exit the positions and put my money to work in other stocks. Stock prices have been volatile lately, even pertaining to good earnings, and I do not want to risk a potential gap down in the share prices.
Hi Alan and Barry,
hope you are enjoying the weekend and that Alan that you are feeling better.
I wanted to ask a quick question regarding using LEAPS instead of the stock as the underlying security and selling calls against the LEAP instead of the actual stock. Wanted to get your opinion on whether this is a good idea or not. I am sure that it has some disadvantages but wanted to see if they were significantly detrimental.
I am using Pandora as an example, just as an example. I am not interested in Pandora right now but for my analysis it is fairly easy to understand.
Please let me know your thoughts.
Regards,
Bobby
Bobby,
There are many ways to make money in the stock market and using LEAPS as a stock surrogate is one of them and will create a strategy similar to covered call writing. I have had my success with cc writing using 1-month options and stocks for my long positions. Here are some points to consider:
Advantages of using LEAPS:
• Less costly than purchasing stock; remaining cash can be used to generate additional cash
• A declining stock will have time to recover
• Low time value of deep I-T-M LEAPS make option ownership similar to stock ownership where intrinsic value changes dollar-for-dollar.
Disadvantages of using LEAPS:
• You do NOT capture stock dividends
• To stay active, you must sell options in cycles that report earnings, taking on additional risk
• LEAPS have a delta of approximately .50 to .60 making it difficult to close a position at a profit for A-T-M and O-T-M strikes (option value has not moved up in step with share value). This is less of a factor for I-T-M LEAPS.
• A higher level of approval will be required by most brokerages to allow this type of trading
• The long calls will ultimately expire and lose value as expiration approaches, stocks will not
• Forced assignment may not allow for a profitable trade
• Wide bid-ask spreads due to the difficulty of pricing securities so far out
• Long-term commitment-may be a high cost to close
• Variability of return: LEAPS do not behave precisely as stocks
• Less likely to be approved for sheltered accounts
***When using this strategy, make sure that the difference between the strikes + the time value generated from the sale of the short calls > cost of the LEAP option.
Alan
Hi Alan,
In the case of AAPL which is going to split 7 to 1 how will that affect a call option if the option is sold or written before the split. Will one contract then be 700 shares? And the premium be adjusted by the split. I.e. if the premium for one contract is $14 (100shares) then if the expiration date is after the split, the premium becomes 1/7th depending on the value of each share and whether the shares are called or the contract expires ITM.
Hope all is well with you during these crazy market swings.
My best,
Richard
Richard,
When there is a stock split or other corporate events like mergers and acquisitions, there will be option contract adjustments for contracts expiring after the split. These adjustments will assure that both buyers and sellers of calls and puts will be made whole…no one has a huge windfall or loss.
Now there is no set formula that all contract adjustments fall into so we need to access information that will detail a particular adjustment but let me give you an example of one way this adjustment may take place:
Let’s say you sold 1 $560 contract and generated $10 per share or $1000 per contract. A standard contract delivers 100 shares. The total contract value is then $56,000. Now the stock splits 7-for-1 prior to expiration. Now you keep the $1000 so that does not change. A possible contract adjustment would be the following:
Your current position is now having sold 7 contracts @ an 80 strike. In this case each contract will deliver the standard 100 but will be worth $8000 per contract, not $56,000. However, you now have the obligation to sell 7 of those contracts which then brings the total value to the original $56,000.
Here’s how to get information on contract adjustments (you can also ask your broker):
• http://www.cboe.com
• Trading resources
• Contract adjustments
• Put in stock ticker
• Click on “search”
• Click on most recent (top) link
Alan
Premium Members:
This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. Look for the report dated 04/25/14-RevB.
There have been changes in THRM, ALK, and SN, based on more current information.
Best,
Barry and the BCI Team