Don’t Forget to Use Protection in Higher Volatility Environments
One thing that’s been apparent in 2018? That volatility is back. It may not be the heyday that some day traders crave, but it’s volatile enough where short-term investors and swing traders finally have something to bite into. Traders love this action, while many long-term investors would prefer the historically low volatility we saw in 2017. However, those same investors can consider using covered calls and long collars to capture more income, boost returns and add protection to their investment.
The question is, should you be using covered calls and long collars? There are a lot of circumstances that come to answering that question. But we’ll make one exception, the first being that you know what a covered call is and how it works. If you don’t, Option Party has a solid explainer piece right here.
Other considerations would be whether the trader is comfortable being exercised on the short call? Meaning that, if the covered call ends up in the money, will the investor be comfortable allowing their shares to be called away. In doing so, there could be tax implications on short- vs. long-term holdings that should be considered. Further, is the investor willing to accept a higher risk profile than other protective strategies (albeit, lower than carrying a naked long equity position) by opting for a covered call strategy?
Assuming that there are no tax implications and that the risk profile is acceptable, then covered calls absolutely should be a consideration for investors amid this prolonged period of heightened volatility.
Trading Covered Calls in High-Vol Environments
A low-vol environment is great for the buy-and-hold investor. It’s also great for the investor that consistently adds to their 401k, IRA or other retirement fund each month. However, it’s not so great when it comes to selling options premium. While the smaller price swings would seemingly make it easier to pinpoint easy strike prices, the lower premiums can be a drag on performance.
It forces credit traders to sell strikes that are closer to at-the-money, thus taking on more risk than they may may be comfortable with. It may also force them to use a larger position size.
Higher volatility works great for investors looking at covered calls as a strategy. Through the first four months of 2018, we’ve had a lot of rallies look promising before ultimately petering out. On those types of rallies, investors with a long position can consider selling upside calls. When done repeatedly to a position, this can significantly reduce the cost basis of the position and improve our returns. Because higher volatility tends to increase options premiums, it means investors can collect more when they sell their covered calls.
Take the PowerShares Nasdaq QQQ ETF for instance. It’s only traded north of $170 for a few days in the first four months of 2018. However, it’s rallied to $170 three times and above $167 four times. In each of those instances, long investors — who may like the ETF for its exposure to Amazon, Alphabet, Apple and others — could have taken advantage and sold upside calls, perhaps the $172.50 or $175 strike.
Odds of exercise would be incredibly low, while premiums would be elevated thanks to higher volatility.
Risks of Covered Calls
There are risks with covered calls, the first of which is exercise. Since this is a “covered” call, it means we have sold 1 call option for each 100 shares of stock we own. If ABC is trading at $48 and we sell the $50 calls, we risk ABC rallying to $55 and only catching $2 per share of that move. Of course, we can make adjustments during the trade, but that’s one risk. The other is not gaining enough downside protection.
Unlike purchasing a protective put, where a position has a so-called cutoff point where all losses become insulated against a decline, covered calls do not. In fact, if we sell an out-the-money covered call, we only protect a small portion of our holdings. In the same example, say we sell the $50 call against ABC when it’s at $48. We may collect $1.25 on that covered call position, but it only protects us against a 2.6% decline in the stock price.
We can sell a lower strike price to fetch a higher premium or choose an expiration date that’s further away. But remember, that increases the odds of our first risk: exercise.
There’s one more risk, but this one is on the trader. Typically one wants to sell covered calls when the underlying stock is approaching resistance, is overbought or has elevated volatility. Together, all three are a great recipe for success. In any regard, selling a covered call after a big decline may fetch a decent premium due to elevated volatility, but remember, even a modest rebound can put our position deep in the money.
If exercise is part of the plan, then great. But if it’s not investors will want to keep the timing of their trade in mind.
Protection With Collars
One way to have a covered call with more protection? By turning it into a long collar. Put simply — and a longer explanation can be found on our blog — a long collar involves selling one call against 100 shares of stock (so a covered call) but also buying a put option for protection.
Effectively, we are creating a limited loss, limited gain scenario. Why would we do that? Take the QQQ for example again. Because its rallies to $170 have been met with more downside than we’ve come to expect, capitalizing on these declines are worth our time. Plus, by having a put in place it limits our risk.
With the QQQ at $170, say we sold the $175 call (knowing that shares would likely hit resistance near current levels) and simultaneously bought a $165 put. Many collar trades can be put on for a net debit of $0.00 or even a slight credit. But most investors don’t do it for the credit. They do it to limit their risk by essentially getting the put option for free. Of course, selling the call limits our upside and is thus the “real cost” in the trade.
In this real world example, the QQQ had gone on to pull back each time. Consider the chart from above: The QQQ went above $168 four times and three of those times declined by $10 or more. In one case it fell more than $20 (over 11%) from top to bottom. The smallest pullback was about $8 per share.
As you can imagine, those “free” puts we have become quite a bit more valuable on these declines. Covered calls and long collars don’t work in every scenario. But they’re just two protection strategies to keep in mind for higher volatility environments.