For any option trader, implied volatility (IV) is
one of the most important considerations because it has a direct impact
on pricing. It has been our experience that IV
increases before an earnings announcement and that this increase is due
to option writers who want to ensure adequate protection of their
portfolios from significant price fluctuations in the market. It is even
more important now as IV spreads have grown
significantly wider, and the concept of a volatility crush
has become an increasingly viable options trading strategy. A fast,
sharp drop in IV will create a
volatility crush
in the value of an option. This often
happens after a major event for the stock, like financial reports,
regulatory decisions, new product launches, or quarterly earnings
announcements. A volatility crush
is an opportunity to take
advantage of a pattern of predictable price movement across the options
market. When we understand premium rates increasing during a substantial
event (like earnings) followed by the decrease in IV,
we can make smarter trades, informed positions, and better moves for the
overall trading account.
With Microsoft (MSFT) a slightly more aggressive
posture is desirable to become more fully exposed to the capital
appreciation profit potential of covered calls. This is
achieved through greater out-of-the-money exposure when initially
establishing covered calls positions. This shifts the moneyness
of the strike prices toward a slightly greater out-of-the-money stance
when establishing covered calls positions for MSFT; and
since economic strength could warrant further tightening we could
substitute substituting some out-of-the-money positions on short
(i.e. inverse) equities for what would normally have been in-the-money
positions on long equities. For example, when the overall market outlook
is bearish, the corresponding new strategy will be to have a percentage
of the total portfolio value invested in covered calls that on-average
are \(1\%\) In-the-Money
using long underlying equity positions with the other percentage of the
portfolio value invested in covered calls that on-average are \(2\%\) Out-of-the-Money
using
short (i.e. inverse) underlying equities.
We also understand that some investors avoid this important strike price selection decision entirely by always picking the same strike price every time (for example, the closest to at-the-money strike price, or one strike out-of-the-money). But we shall pursue a more active decision-making approach. The advantages are:
Higher potential annualized return-on-investment results; and
More frequent opportunities to adjust the strike prices of subsequent positions based on up-to-the-moment stock prices and current market trends.
At-the-money
strike prices if the overall market meter
is neutral; out-of-the-money
if bullish; and
in-the-money
if bearish. And since we can calculate our
expected value return-on-investment for all covered call positions we
are considering prior to entering the trade, we can partially
systematize our financial decision making.
Last but not least, since each time we enter a new buy/write limit order we make a forecast either on gut feeling which cannot be systematized, or using fundamental analysis, we should then ensure that our strikes and the horizon we are trying to predict price movements for, is in line with overall market meter sentiment indicator. We also understand that sometimes our market meter will be right and sometimes it could be wrong, but over time it should help us in two primary ways: (i) it will help us to read more and thus learn more about the myriad factors that influence the companies that we invest in; (ii) it gives us a slight return-on-investment edge compared with always using the same strike price.