May 15th, 2007 by John Brasher
Implied volatility (IV) is the level of stock price volatility implied by an option’s price, expressed as a percentage. For example, 35% is normal rather than high, but 85% is rather high. An abnormally high option price suggests - but does not actually forecast - imminent higher volatility in the stock’s price. There are three main reasons why premium and therefore IV get high:
News about the company is pending, and the market expects that the stock may move. Wall Street and smaller traders make money on movement and thus are willing to pay more in this case. The news may be earnings or almost anything.
The stock is actually moving now, which is even better than high option premium’s hip-wiggling suggestiveness that it may move. There tends to be a skew towards the calls on a stock’s price rise, and a skew towards the puts when it’s down.
The stock just has a high level of IV as a normal thing (and there are more of these than you might think). When this is the case, then the high premium you see is not abnormally so. For example, ATI has been perennially at or close to the top of our S&P 100 list of the highest covered call returns for many months, due to its strong uptrend. RMBS is another example, for its tendency to soar and crash.
Covered call writers love high-premium plays, but we have to pay attention to the fact that premium is high for a reason. Since IV just might be high because of impending news, and that news could be very important, it pays to look for news. Searching out the news is not an absolute requirement for covered call success, but the smaller, less established and less profitable the company is, the more important it is to track down the source of high IV.
Stick with established, profitable companies that are growing earnings – always the best bet for covered calls.
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on Tuesday, May 15th, 2007 at 8:19 pm and is filed under Covered Calls, Trading Tips.
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