Covered Calls and Volatility

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Volatility plays a key role in any option strategy and covered calls are no different. Volatile stocks provide more option premium but they also come with more risk. Taking a look at a few different stocks, you can see the difference in return potential for low volatility stock and highs volatility stocks.

Covered Calls and Implied Volatility

As we learnt in the previous lesson, the higher the implied volatility, the higher the option premium. It also means there is a higher risk that the stock will exhibit large moves in either direction which is not really what you want as a covered call trader. Covered call investors also don’t want to trade a stock with implied volatility that is too low as the premium you collect will also be low. Each trader will prefer different stocks with different levels of implied volatility depending on their risk tolerance.

Implied volatility will also vary across different expiry dates for each stock. For example, if a company has an earnings announcement during the October expiration month, the implied volatility on the October call options is likely to be much higher than the September options.

The September options will have expired long before the earnings announcement, and therefore there is less uncertainty around where the stock will trade during that expiration cycle.

The October expiration cycle contains a pretty big unknown factor, therefore the market makers price in the chance of a significant move in either direction. This makes calls (and puts) more expensive. This increases your yield potential on a covered call, but keep in mind there is the risk that the stock could gap up or down by a significant amount in either direction.

Covered Call Implied Volatility

Now we know that not all implied volatility is created equal, let’s look at some possible reasons. We know earnings is one reason, but what else can cause the implied volatility of one stock (or the options within a single stocks option chain) to be different?

– Political events

– News

– Rumors

– Supply and demand

– Market psychology and outlook

– World events

You can check implied volatility levels using you broker platform and investigating the option chains. Failing that is a great resource for checking IV levels. One thing I love about this site is that you can see where implied volatility currently sits compared to where it has traded over the last 12 months. This way, you can get a gauge on whether implied volatility is currently cheap or expensive.

Below you have see the chart of Implied Volatility and Historical Volatility of XOM over the past 12 months. You can see the XOM seems to have a cap of about 18-20% when it comes to implied volatility. When you see XOM’s implied volatility get up towards these levels, it can indicate that it’s a good time to sell covered calls. Of course, remember to check the IV of the individual option strikes and also check for earnings!

Implied Volatility covered call

In the chart above, you can see that the historical volatility spiked up around the end of July. On July 31, XOM dropped from $103 to $99 on the back of their earnings announcement which resulted in the spike. Notice also that implied volatility did not jump nearly as much as historical volatility. This is because historical volatility measures past price moves and implied volatility measures future moves.

In this example, the implied volatility of XOM is 14% and the stock is trading at $97 as of September 19th, 2014. An IV of 14% indicates that the market is expecting a move of 14% in either direction over the next 12 months. In other words, market participants expect XOM to trade between $83.42 and $110.58 between now and Sept 18th, 2015. The likelihood of this occurring is around 68% (1 standard deviation). Knowing this, can help you plan your trades. Of course., keep in mind that expectation doesn’t always match reality and nothing is ever guaranteed in the stock market.

Implied volatility is an important component of covered call writing, learn as much as you can in order to improve your covered call returns.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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