Blue-Chip Volatility Writing
This is a strategy popularly employed. We execute it by finding large-cap (blue-chip) stocks that:
1) are somewhat more volatile than the overall market and have a corresponding level of implied volatility, assuring good return, or
2) even if not very volatile – carry a backdrop of rather high volatility expectations due to well-known company issues and thus have enough implied volatility to generate good call writing returns.
3) Pay an annual dividend whose yield is at least 6%.
When not called out, we re-write the stock. This strategy involves low stress and a low activity level, meaning that as little time as possible is spent picking and managing trades.
This strategy definitely puts a lot of weight on stock selection and tends to favor large “defensive” stocks, meaning the ones investors buy for their safety factor and dividend. The fact that so many people and institutions want to own them is the source of their stability. The old saying that nobody ever got fired for buying IBM could apply as well to the stock as the equipment.
The BCV writer tends to look for:
- Large-cap stocks that are industry leaders (e.g, blue chips);
- While a stock that has been “spanked” in recent times and established a new trading range is often preferred, this is not necessary – the stock can be making highs;
- A low-to-medium level of historical volatility (20% – 40%) but higher implied volatility, due to a backdrop of volatility expectations, which tends to result in good premium every month;
- A historical volatility level of 30% – 60% with in-line implied volatility; these tend to offer quite good levels of call writing return month after month.
Though you may not be a fan of passive buy-and-hold investing, this blue-chip writing strategy is income investing with a vengeance. Despite what many will tell you, trading giant companies is different; they tend to move glacially compared to small ones, and hold their price better in bad times. Another interesting fact: just as small caps and techs tend to lead a stock market recovery, the blue chips tend to outperform in the latter stages of bull markets and in bear markets.
As we saw when comparing volatilities in a previous articles, the blue chips generally are just less volatile, but can still offer wonderful returns in the 3% to 5% range per month, and stunning annual returns. This technique can work with smaller companies, but they are not as stable through thick and thin as the blue chips.
A popular strategy, which some writers use all the time, is to look for stocks that are down on a day when the market also is down. Known as down-day writing, this strategy assumes the stock will snap back when the market moves back up, giving the writer a natural advantage by purchasing the stock more cheaply than would otherwise be the case.
Figure 6.5 Table – Down day writing comparison
Down-Day Writing Comparison
|Strike||Stock Price||$20 Call Premium||Cost Basis||Called Return|
|Write stock at $20||$20.00||$1.25||18.75||$1.25 (6.7%)|
Wait until stock drops to $19
|Write stock at $19||$19.00||$0.80||18.20||$1.80 (9.9%)|
Wait until stock drops to $18
|Write stock at $18||$18.00||$0.45||17.55||$2.45 (14%)|
Figure 6.5 compares the results of writing the current-month $20 Call in three scenarios. Placing the buy-write trade when the stock is $20 brings in $1.25 of premium, for a very decent 6.7& return. However, catching the stock on a down stock-down market day, we pay only $19 for the stock. The $0.80 call premium is lower, but the $20 Call is now out of the money. If assigned, we will pick up an extra dollar in profit, bringing the return to $1.80 – almost 10%.
Buying the stock even lower, at $17, and writing the $20 Call for a $0.45 premium, positions us to make a profit of $2.45 (14%) if assigned.
Figure 6.6 Chart- down day opportunities
This figure illustrates the down-day technique by comparing daily charts of Target Corp. (TGT) and the S&P 500 index (SPX) from early 2009.
From mid-March through June 5, which is approximately 55 trading days, there were six separate instances in which Target pulled back with the broader market. Target pulled back on a few days when the market didn’t. The market also pulled pack at times when TGT did not.
It is important that both the stock and the S&P 500 be down simultaneously. Ideally, the Nasdaq Composite also would be down, but the purpose of requiring that market and stock both are down is for comfort that the stock is not weakening against the market. A stock pulling back on a good market day is not an entry point for long stock!
Instead of seeking stocks likely to move in the short-term, this strategy relies on a snap-back in the stock along with the overall market, rather than reading the technical tea leaves. It also furnishes a reason for writing OTM calls to increase returns. Since we should always have an articulable reason for writing OTM, the down-day technique supplies it.
The writer can either write an OTM call on trade entry or leg in to the trade, both discussed earlier. It can seem a scary technique at first. But it will also teach you to trust market rhythms. And it will significantly enhance returns.
Technical writing is a catch-all term for any write in which the investor is constructing the trade to take advantage of the stock’s expected price movement. Writing OTM calls on a short-term bullish expectation for the stock is a technical write. Writing deeply ITM calls on a portfolio stock at a resistance level (expecting a pullback) arguably is another.
Down-day writing clearly qualifies, since it relies on a bullish expectation of a “natural” rebound of the stock with the overall market. Any write that seeks to take advantage of what the chart is showing us could be termed a technical write. In fact, this is what adroit call writers do much of the time. Though we are not really technical or directional traders, why would a call writer ignore the chart?
Favorite examples of mine are OTM leg-in writes on stocks that have pulled back to test the 50-day moving average or have pulled back to successfully test the bottom of a trading range. There are many others, of course. By legging in, we choose when to pull the trigger. And it beats the pants off the technique of rolling up calls to try to capture more profit from a hot stock.