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How To Take Advantage Of Market Volatility With Covered Calls

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It's time to start thinking about covered calls as amplifying COVID-fears coupled with monetary uncertainty in the face of unending inflation drives a market pullback. The indiscriminate selling we've seen since Thanksgiving has been driven up implied volatility (IV) on options across the equity market, presenting us with a Theta-catching opportunity.

Covered calls will allow you to capture returns on stocks you already own or buy new shares of enterprises you've waiting to acquire at a discount.

What's A Covered Call? 

Implementing a covered call strategy involves selling out-of-the-money call options on a stock that you own or want to purchase and collecting the premium that each call option yields you. This means that you are effectively sell-short the options contract.

Your P&L on this option play would be inverse to the call's premium because you are effectively short in the derivatives market once you enter the trade. However, the underlying shares that you own protect you from any losses (aka covered call), making these trades risk-free (if you don't account for opportunity loss if the underlying stock soars above your strike).

When executing a play like this, you have to remember that each option contract represents 100 shares. Meaning you should only write (or sell) call contracts for each block of 100 shares that you own or would like to own.

The Greeks To Focus On

Theta is the rate at which an option loses value each day if the underlying security does not move and represents the expected daily returns of a covered call, assuming that the strike price is not reached prior to expirations. Theta (quoted as a negative figure) and implied volatility are directly correlated on an absolute value basis (aka disregarding -/+ signs).

Theta and Vega, an option's sensitivity to implied volatility, are the most meaningful metrics to focus on when implementing a covered call strategy. As an option seller, we want Theta (expected daily returns) to be high on an absolute basis, while Vega (volatility risk) remains low.

When assessing opportunities for covered calls, I'm looking for options with an IV of 50% or higher in combination with a Theta to Vega ratio that exceeds 0.25. The higher the Theta Vega ratio, the better the risk/reward outlay for option sellers (no matter what your strategy).

Risk Of Writing Uncovered Call

Selling call options is extraordinarily dangerous if you don't own the underly security because your downside is unlimited (similar to short selling a stock except leveraged due to the nature of options nature).

To help you conceptualize this, imagine you sold a 1-Year out Alphabet (GOOGL - Free Report) call in September 2020 for a September 2021 monthly contract (Sept 17th Exp.) at a $2,500 strike for a quoted $20 per share premium, with zero shares held.

Now, most people in their right mind would think that there is absolutely no way that GOOGL, trading at $1,450 at the time, would be able to rally over 72% in the next year. Perceptively it was a 'low-risk trade,' despite not owning the $145,000 worth of stock needed to make this trade truly risk-free (100 shares).

This trade would have provided an immediate credit of $2,000 ($20 quoted per share premium x 100 shares = $2,000), but as GOOGL rallied, your position would have quickly turned against you. Since you are short the call, every dollar the premium moves up is a dollar against your position as you would have to repurchase the call at market value to flatten your trade.

Let's say you held on to this until it expired, assuming you didn't have the required shares on hand, you not only would have lost the entire $2,000 premium that you were credited a year prior but would now have to pay the difference between the $2,500 strike and $2,816 spot price of the stock. This would have run you $31,600, (($2,816 – $2,500) x 100 = $31,600).

This trade risked an endless amount of capital for a measly upside of $2,000. Your brokerage account would have almost certainly sent you a risk alert or a margin call before you were able to lose this much (likely requiring $50k in liquidity), but this exemplifies the outsized risks involved in selling an uncovered call option.

Now let's say you did own the necessary underlying shares when you sold the 1-year call on GOOGL (covered call). The trade would have yielded you the initial $2,000 credit, and you would have been making money on the underlying shares all the way up to $2,500. The transaction would have returned you ($2,500 - $1,450) x 100 + $2,000= $107,000 or a 74% profit.

Since you owned the underlying shares, you still wanted the stock to go up, and the predetermined strike price you initially sold the call at was merely your exit price.

How To Take Advantage 

FUD-fueled (fear, uncertainty, & doubt) market selloffs like these are the best times to execute a covered call strategy because the short-term surge in volatility causes the premium of these options to spike (seen as an increase in Theta on an absolute value basis). The higher the implied volatility (IV), the more uncertain the stock's future price is, which is reflected as an increase in the option's value. This allows you to capture a larger credit on the calls you would like to write.

Remember only to sell calls that are tolerably out-of-the-money (above the market price of underlying shares) to ensure that you capture both the option credit and any potential upside in the share price if the stock does end up rallying to your strike price before expiration.

There are a couple of crucial judgments you need to make when trading covered calls: what price you are willing to sell your stock at and whether you believe the market's volatility?

If I write longer-term covered calls (6 to 18 months till exp.), I typically choose a strike price that I have predetermined as my price target (where I am willing to let go of the stock). If I'm selling a short-term covered call (1 week to 3 months till exp.) I can take advantage of near-term volatility, with the flexibility to roll the calls over each time the prior one expires if the volatility sustains (similar to a high-yielding fixed-income security).

Buy-In Strategy

If you are looking to add equities to your portfolio with a size of 100 shares or more, it may be prudent to sell a call option simultaneously. Growth-oriented tech stocks are what I am focused on because of this cohort's recent valuation compressing underperformance and significant levels of Theta driving volatility.

Stocks I'm looking to add are positioned for the next generation economy like AI-power customer service automator Twilio (TWLO - Free Report) , best-in-class cybersecurity platform CrowdStrike (CRWD - Free Report) , and real-time machine data management powerhouse Splunk (SPLK - Free Report) . These stocks have long-term winners but are experiencing significant short-term uncertainty in the face of an increasingly hawkish Fed and broader market pressures for the latest COVID-related restrictions.

These nascent tech enterprises hold a leadership position in their niche operating segments and have a compelling growth narrative that shouldn't be ignored. They will undoubtedly play a vital role in the commencing 4th Industrial Revolution, which is already rapidly digitalizing our global economy.

Take a look at your portfolio and examine stocks where you hold a 100+ share position (1 call per 100 share block), with the highest IVs to capture the most Theta. This call selling tactic will not make you rich quick, but it is a savvy way to capture returns in a down-trending market.

Make sure you are willing to exit these covered call positions at the strike price you chose. I am looking to sell December 17th expiring calls (the most liquid short-term monthly contracts), which will allow me to roll these calls over if FUD continues to plague the market by the end of the year.

I remain bullish going into 2022 and am buying this stock market dip.

Happy Trading!

Dan Laboe

Equity Strategist & Editor of The Headline Trader Portfolio


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Splunk Inc. (SPLK) - free report >>

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