High Volatility Covered Call Strategies

Volatility Call Writing

Definitely not a beginner’s strategy, but more of a trading strategy, this one is based upon trading the calls as the stock moves. For this to work, we want a solid, profitable company which happens to have a fairly large average true range (ATR, the average daily trading range) of several dollars. Such a stock moves a good bit in the course of the week, sometimes during a single day.

Volatility traders prefer the deeply ITM call for the current month because of its high delta, which causes the option’s price to move closely with the stock. The delta will usually be at least 80%, and higher is better. The calls are written at the top of the ATR on the expectation of buying them back when the stock moves down in its range. On the right stock, it may be feasible to sell and close the calls several times in the span of a month, yielding a return that can easily exceed 8% a month.

This strategy relies on trading for the generation of profits. Obviously, capitalizing on such trades requires monitoring them closely in order in order to seize upon moves that yield a worthwhile profit.

Writing LEAPS Calls (Simulated Certificate of Deposit)

This writer prefers not to be bothered with monthly buy-writes and does not want to worry about trade management more than absolutely required. The technique is to write LEAPS or longer-dated calls, usually with an expiration 9 to 15 months out. High-quality stocks are chosen, stocks that would be welcome in the portfolio. Non-volatile stocks are wanted for this strategy; and only larger, more robust companies tend to have LEAPS options trading.

But the fact that LEAPS calls are available does not alone qualify it. Where the stock is in the trading range may dictate your strategy. Figure 6.7 examines possible LEAPS strategies on Kyphon Inc. (KYPH), a stock trading at $39.82 when this table was generated in October 2006. It is roughly in the middle of its 52-week trading range, with respective high and low prices of $46.87 and $29.95. The following table suggests some strategies using LEAPS calls expiring in January 2008, approximately 14 months away as this example was prepared:

         Figure 6.7

Covered LEAPS – Writing Comparison
KYPH – $39.82 at Oct-2006 January 2008 Leaps Calls	Premium	Time Value Premium	Breakeven	Flat Return	Called Return
OTM – Jan08 45 Call	5.40	5.40	34.42	15.7%	30.7%
ATM – Jan08 40 Call	7.50	7.50	32.32	23.2%	23.7%
ITM1 – Jan08 35 Call	10.20	5.38	29.62	18.1%	18.1%
ITM2 – Jan08 30 Call	13.40	3.58	26.42	13.5%	13.5%
ITM3 – Jan08 25 Call	17.10	2.28	22.72	10.0%	10.0%

This technique is not at all exotic – we are simply writing a call option with an expiration date pretty far out there. You should expect returns to be lower than when writing short-term calls, but that is not the major consideration for all investors.

ITM Strikes – Simulated CD: The ITM calls create what is known as a Simulated CD, because its performance mimics a bank certificate of deposit. The three ITM strikes (25, 30 and 35) all lower the position’s breakeven cost below KYPH’s 52-week low ($29.95), an important safety factor in conservative writing of LEAPS calls. Writing these ITM strikes would essentially mimic a bank certificate of deposit, yielding returns for the 14-month trade duration ranging from 10% (8.6% annualized) to 18% (15.5% annualized).

Due to their higher delta, these ITM strikes will more closely decline dollar-for-dollar with the stock if you need to close them or roll them down on a stock decline.

ATM $40 Strike: The 40 LEAPS Call offers a great 23.2% return (19.8% annualized), though the if-called return is only a little better. The call’s low delta means premium will be slow to decline with the stock if it pulls back.

OTM $45 Strike: The 45 LEAPS Call clearly is the most aggressive of all possibilities shown. The uncalled return is “only” 15.7% (13.4% annualized), less even than that of the ITM 35 strike, so there is little reason to write it unless quite bullish. More to the point, the calls will not be exercised unless they are in the money at expiration. It is quite possible the stock could soar up before expiration, then pull back, in which case the calls would not be exercised. The OTM call’s low delta means premium loss on a stock drop will be slow.

The choice of which LEAPS strike to write would depend on your goal in the trade, as well as your assessment of KYPH. Of course, you could use a 2009 LEAPS call, but the premium is not appreciably higher for the additional 12 months the trade would entail – in some cases little over $2.00 additional premium would be brought in. And the trade also could be built with calls six or more expiration months out in time, rather than using LEAPS calls, if time value were acceptable.

Writing High Implied Volatility

This position is put on when 1) implied volatility is high, but 2) the stock is not especially volatile. As noted in the previous chapter, this happens because an impending event causes IV to spike well above historical volatility. The expectation is that implied volatility and therefore time value premium will collapse – but the stock price will not collapse – allowing the call to be bought back at a price far less than its selling price, creating a profit. This technique can work quite well, and works even better when the stock rises on the event. See Figure 5.19 for an example.

The key to this trade is that the writer does not expect the stock to sell off. If the stock is highly volatile and the high IV is in line with it, then it is a risky covered write. Thus, as always, solid, stable companies are to be preferred for which the news event pending (frequently, earnings) is not likely to produce actual price volatility in the stock. Major news on a small company, for example, is a risky write. Even the largest companies undergo large spikes in implied volatility, usually in conjunction with earnings.

Though it can happen, most stable, profitable companies do not become volatile upon resolution of a news event driving IV high. This must be measured stock by stock, of course; the writer must examine the nature of the news event relative to the company’s size and financial prospects. If the spike in IV is not caused by a volatility event, this trade does not work as well, because there is no operator to collapse the high IV.

Without doubt, this technique is riskier than many others, but also offers high rewards. When writing is confined to the best of the best companies, the risk is quite manageable. I find it interesting that many covered writers who seek only high returns do this without realizing it.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.