When implied volatility (IV) levels are at all-time highs, option buyers have to know that they’re playing with fire. When the market quiets down (and sooner or later it always does) IV’s and options prices are going to come down. So what can an options trader do in a high IV environment so that the coming decline in IV works in his favor? In a word, find ways to sell options.
There's Always Covered Writing
The obvious (and safest) way to sell options is “covered writing” – where you sell call options against existing stock holdings, or buy new stock holdings and sell calls against them. These are often called “covered” calls, because you own the underlying. The drawback to covered writing is that if the stock falls a lot, your short calls do not help cushion the fall beyond a certain point. Also, if a decent rally develops your upside potential is capped by the short calls. The picture below shows the risk graph of this trade using Amazon.com (Symbol: AMZN) as an example:
Selling Naked Puts: The Same Risk but with Less Capital
Another way of selling options, very popular with well-heeled investors, is to sell naked puts on stocks the investor wouldn’t mind owning. Typically, at-the-money or just out-of-the-money puts are sold. If the stock stays around the current price, or advances, the investor keeps the (currently generous) premium after the option expires worthless.
What if the stock declines in price? In that case the investor will be assigned the shares. The cost basis for these shares will be the strike price of the put minus the premium that was received for selling the put. That’s why naked put writers should be prepared to buy the stock (and make sure they have the funds available) before entering this position.
For example, Amazon.com is currently trading at $36.25. An out-of-the-money put with a strike price of 35 can be sold for 2.10 ($210 each). The $210 is yours to keep, no matter what. Worse case, you’ll end up paying $3,500 for 100 shares of stock. Subtract the $210, and your effective cost basis is $3,290, or $32.90 per share. Not a bad deal!
As you can see below, the risk graph is the same shape as the covered write strategy, but requires a lot less capital while offering a higher yield
The only drawback to this strategy is that if the stock moves higher after you sell the naked puts, you’re never assigned. Since you don’t own the shares you won’t participate in the rally. Thus, selling naked puts cannot be counted on to get you into the best performing stocks. In fact, it may tend to get you into less than the best performing. (Or at least those that decline first before moving up.)
Combining These Strategies for a Covered Combo
What if you are you looking for sideways movement in the market?A beautiful strategy for that scenario is a combination of the above two strategies. When you add a naked put sale to a covered write, you get what is called a covered combo. The covered combo is always a fantastic strategy to use at extreme volatility levels.
Look at the covered combo example in Amazon above. With the stock currently trading at $36.25, you’re paying an effective price of only $32.55 per share. The prospective yield on this 131-day investment, if the stock holds up is 10% (27% annualized). And If the stock rallies higher during this time, you could get a return as high as 18% (51% annualized). Wow!