October is known for color change, the risk of first frost, and the World Series chase. And, of course, October is a month when spooky things walk up and down your street, and often Wall Street, too.
While it’s true that volume and volatility have cooled from their August flare-up, some measures of the option market’s mood—the put-to-call ratio among them—are still elevated. That means it may be time to brush up on option strategy, including covered calls.
New “Normal” for VIX?
Indeed, the recent rise in the CBOE Volatility Index (VIX) may suggest that investors are bracing for volatility in October—a month that history shows has been typically pretty volatile (scary to some and ripe with opportunity to others). This October features another too-close-to-call Federal Reserve interest rate meeting and a round of earnings reports that could shed light on the repercussions from China’s economic slump.
VIX, the market’s so-called “fear gauge,” is typically viewed as a forward-looking indicator because it reflects the implied volatility priced into short-term S&P 500 Index (SPX) options. The index remained in a range between 20 and 30 through most of September, dipping below 20 only briefly on one occasion, when it touched 17.87 intraday on September 17 (figure 1). By comparison, the average reading from VIX during the first six months of 2015 was 15. The index closed above 20 less than a dozen times in 2014.
But, overall trading activity in the options market has slowed from the frantic pace seen in August. August 21 marked the second highest volume day on record, with nearly 40 million puts and calls traded across the dozen options exchanges, according to exchange data. The average daily turnover through the first few weeks of September had dropped to 16.6 million contracts. Put options, of course, represent the right, but not the obligation, to sell the underlying security at a predetermined price and over a set period of time. Call options, on the other hand, represent the right, but not the obligation, to buy the underlying at a set price and time.
The Options Clearing Corporation (OCC) computes the daily put-to-call (PC) ratio. OCC crunches exchange put volume divided by call volume. The PC ratio hit an extreme of 1.47 on August 21 when roughly 15.9 million calls and 23.4 million puts traded across the exchanges. And, the PC ratio is averaging 1.08 for the month, which means it’s running higher than the 10-day average, charted in figure 2 below.
Note that while overall options volumes are off the brisk pace from a month ago, put activity remains elevated, just as that next earnings round dawns and the Fed guessing-game continues.
Tom White’s RED Option Strategy of the Week: Covered Calls
Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
Trick or Treat? Broad-market pain sometimes delivers individual stock opportunity, especially for traders who’ve put in the work researching a particular ticker. What happens to those good intentions when your “idea stock” has taken a beating alongside its brethren?
One strategy to consider is the covered call, also known as a “buy-write” position. A covered call consists of a purchase of the underlying instrument at the same time as a call sale on that instrument. Implementing the covered call strategy involves buying (or owning) 100 shares of a stock and then selling a call that is "covered" by the stock (since one options contract usually controls 100 shares of stock).
The long shares in the underlying instrument are considered to provide the "cover" as they can be delivered to the buyer of the call if the buyer decides to exercise her option. “Writing” the call generates income (minus transaction costs) via the premium the trader pockets with the call sale. The position is designed to typically enhance the overall return of a long, or bullish, trade. It can also lower the initial break-even price of the trade. However, the covered call strategy will limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.
This strategy is typically used when a trader would like to generate income from a long stock position while the market is moving sideways or slightly higher. It allows a trader to continue a buy-and-hold strategy, yet ideally make some money off a stock that’s gone inactive. The trader must correctly guess that the stock won't make substantial gains within the timeframe of the option; as such, some traders opt to write an out of the money option. As with most strategies, there’s a trade-off. A covered call doesn't have as much upside potential as other types of options because gains are capped due to the short call. And keep in mind, the risk to the underlying security is not lessened. If the stock price falls, the investor potentially loses the amount invested in the stock, less whatever premium they received when they sold the call.
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