When stuck in a low-volatility environment, check out the term structure. You might consider alternative covered call strategies.
When summer trading is slow, and everyone’s either at the beach or wishing they were, implied volatility (IV) can get pretty low. For covered call sellers, lower IV means bringing in less premium. That doesn’t mean you have to give up your covered call strategy altogether, nor does it mean you have to live with lower premiums. But it might require a shift in your thinking, and perhaps your strategy.
To offset low volatility, you could choose a strike closer to at-the-money, but that will increase the likelihood of having your stock called away if the option is in the money at expiration.
Alternatively, you could move your strike selection further out in time. Some covered call sellers prefer to stick to calls with less than a month until expiration, because short-term options tend to decay more quickly than long-term options. But the choice might depend on what the volatility curve is doing. Also called the “term structure,” the volatility curve is a graphical representation of the implied volatility levels at each expiration.
Why does the term structure matter? When implied volatility levels are all pretty much the same from expiration to expiration, or when the shorter-term expirations are higher than the longer-term, selling a shorter-term option over multiple expiration cycles can bring in more premium collectively than selling one longer-term option would.
Let’s say, for example, that XYZ is trading for $50. The 55-strike call ($5 OTM) expiring in a month is trading for $1, and a three-month 55-strike call is trading for $2.50. You could sell the call for $1 today, and if the option stays OTM at expiration, and IV stays about the same, you could sell another call that’s $5 OTM for $1 or so, and again the following month if conditions remain the same. Over the three-month period, this strategy would have brought in about $3, which is more than the $2.50 for the three-month option. But don’t forget those transaction costs, which can pile up with the monthly strategy.
There are times when shorter-term volatilities are so much lower than the further out volatilities that the longer term might be worth considering. And that can certainly be the case when IV is low. For example, figure 1 shows the term structure of futures contracts based on the CBOE Volatility Index (VIX), a measure of the 30-day IV of the S&P 500. The steep upward slope of the curve shows the market’s expectation of higher IV in the future. During periods of low volatility, many stocks reflect a similar term structure.
FIGURE 1: VIX TERM STRUCTURE.
The front-month VIX futures contract is trading around 11.5. Longer-dated futures contracts are trading significantly higher. Data source: CBOE Futures Exchange. Plotted through July 26, 2017, on the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Your stock may have a similar volatility curve. Here’s an example with some theoretical numbers. Let’s say a stock’s trading around $146 and the 150 call option with 24 days left to expiration is worth about $0.45. See the table below. This is the “summertime” implied volatility, and it’s 10%.
You could sell this call and collect $0.45, and if the stock price and implied volatility are the same in 24 days, you could possibly sell another call for $0.45. That would give you $0.90 of premium collected over 48 days. Of course you would have transaction costs on both trades, which would eat into that $0.90 compared to one trade.
However, if you instead sell the 150 strike that has 52 days until expiration and has an implied volatility of 14%, then you’d collect $1.20 in just one trade. That gives you 33% more premium than the $0.90 you collected from two trades, for about the same period of time.
Yes, summer can mean lower IV, and thus lower premium for covered call sellers, so it might help to look at the term structure to help determine the most appropriate trade for your objectives.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.