April 25, 2006

Implied Volatility and Covered Calls
The Role of Implied Volatility in Covered Call Writing
by John Brasher, CallWriter Publisher

When option premium gets abnormally high (the option is overvalued), it is said to imply future volatility in the underlying stock. A lot of people believe that implied volatility is important when doing certain types of option trading. Is it helpful in covered call writing? In my opinion, no.

What Implied Volatility Is

To get to my ultimate point I need to briefly discuss some options theory. Stock prices change constantly, and volatility is the measure of the rate and magnitude of the price changes. Historical volatility (a/k/a statistical volatility, or SV), which is expressed as a number, indicates how much a stock's price moves around over a period of time, most commonly measured over a year.

The Black-Scholes formula - for which Fisher Black and Myron Scholes won the Nobel prize - is used to calculate the fair market value of an option, and one of the formula's inputs is the underlying stock's annual volatility (its SV). We are of course talking about the theoretical fair value of an option; the markets are not so neat as this formula. SV is expressed as a percentage - for example 37.5% or .375. When stock option premium is high, meaning that the option is overpriced according to the Black-Scholes formula, the premium is said to imply future volatility in the underlying stock's price; and we can determine just how much volatility is implied. When an option is overpriced, the B-S formula can be used backwards, to solve for the annual volatility that would have to be input into the formula in order to obtain the high option price - and the volatility so calculated is called the implied volatility (or just IV) for the underlying stock.

Here's how it works... suppose the historical volatility (12-months) of hypothetical company XYZ Corporation (XYZ) is 49% - also expressed as .49 - we can determine the fair (theoretical) price of an option. If the option premium is higher than that, it implies higher than normal volatility in XYZ. Here are the assumptions we'll input into an option calculator to determine the fair price of the XYZ 40 Call:

In other words, our goal is to solve for the value of of X - the fair option price. A basic option calculator tells us that, assuming the above inputs, if the historical volatility entered for the stock is 49%, then the 40 Call should be priced at $1.00 (actually $1.0125, but I'm rounding it down since option premiums are quoted in nickels).

But options are not priced in accordance with the Black-Scholes formula; they are priced on market expectations. If we know the call's actual premium, then we can instead solve for the level of volatility implied. So if we input different premiums than $1.00 for the 40 Call into the calculator, it will tell us the volatility level implied by each premium. Here are some of the volatilities implied for this stock by different premiums on the 40 Call, all of which are slightly rounded:

According to the Black-Scholes formula, then, a call price lower than $1.00 implies a lower volatility than the historical 49%; and higher premiums correspondingly imply increasing levels of volatility. For example, a price of $2.50 for this 40 Call implies a volatility of 88% for XYZ.

This formula is the almost universally accepted method of calculating volatility and fair option pricing - and of course, implied volatility. For example, I have seen accountants use it in calculating the value and tax effects of employee stock option grants. But despite its usefulness, the market prices options in accordance with its expectations for the underlying stock. If the market does not expect price movement in the underlying stock, the option prices will be more in line with the stock's historical volatility. Thus a volatile stock like Rambus (RMBS) will typically offer high option premiums in accordance with its higher historical volatility; and options on a low-volatility stock like Walmart (WMT) will seldom offer much of a return.

Free calculator: you can download a simple option calculator for free at Trader Soft. This calculator computes the Greeks for you and will also compute volatility and the theoretical option price for you. Though I don't often recommend other sites, those of you without access to such a calculator from your broker or other source may find this calculator interesting and useful. This calculator is completely different from CallWriter's famous Trade Management Calculator™, which is designed to help traders manage open covered call trades.

What Causes High Option Premium

High premium implies the stock is about to become more volatile than usual; low premium implies less volatility than normal. The higher the premium, or rather the more overvalued the premium, the more volatility is implied. IV is just a fancy way of saying that the market thinks the underlying stock is about to move. IV is not a forecast, and certainly not a promise, of actual volatility. IV typically gets high when the company has news or some event impending that could move the stock - I call it the event horizon - and I refer to this kind of volatility as event volatility. But event volatility is not the only cause of high premium. Here are its main causes:

• Significant news is pending on the stock (earnings report, FDA ruling, etc.)
• Significant news is pending on a larger company in the same industry that the underlying stock follows
• The stock has a high level of historical volatility, so its options normally are expensive
• The stock is currently volatile (moving), so its options are expensive
• Anomalous cases - there is no apparent reason for expensive options

If the stock is already moving, options will be more expensive on it; otherwise, Wall Street would be giving money away. If a stock is moving up smartly, you can expect call options to be expensive. In the anomalous cases, no important news is pending on the stock or a more dominant stock in the industry, the stock is not historically volatile and not currently moving; in such cases, I expect the high option premiums are the result of market manipulation. These anomalies typically are small companies whose stocks are lightly traded, and the options on them very illiquid. You will seldom see these on CallWriter lists (except the Pharmaceutical and Low Volume lists), because we filter them out of our other lists.

What Implied Volatility Means in Practice

In my experience from watching many thousands of high call premiums over the years, only a relatively small percentage of stocks with high call premium actually move significantly when the event horizon occurs. Again - in my experience - neither the fact of IV nor even the level of IV reached is a reliable predictor of actual volatility. And even when a stock does turn out to be volatile, IV certainly does not predict the direction of the movement. If IV really predicted the underlying's future price movement, we'd all buy the options with the highest IV, because they would be telling us where the underlying's price was going. It just doesn't work that way. I've never seen evidence that high IV, or the way in which IV is skewed, has any statistically meaningful predictive power.

So what does a high level of IV really mean, since it is not a usable forecast of actual volatility? The answer is no mystery - it just means that traders are willing to pay more for calls on stocks that they think may be about to move. This is why option premium gets high; market makers charge more because traders will pay more. In other words, it's supply and demand. When a hurricane is heading for Florida, plywood gets expensive, and it's the same principle.

Think about that. An event horizon is impending (maybe a lawsuit resolution, perhaps critical union negotiations), and traders are willing to pay more for options, so Wall Street jacks up the option premiums. If you were Wall Street, wouldn't you? That's the nature of free-market pricing. All that the high premium and high IV really mean is that traders are speculating on a price move and are willing to be price-gouged by Wall Street.

According to the Chicago Board Options Exchange (CBOE), only 10% of stock options are exercised. 10%! The remainder are either traded out (bought or sold to close) or expire worthless. Roughly half of all stock options are traded by hedgers, and half by speculators. When options become overpriced due to an event horizon, both hedgers and speculators buy them - hedgers out of caution, speculators out of greed. Logic suggests that far more than half of overpriced options are bought by speculators, because hedging professionals pretty much stay hedged all the time.

So high option premium - overpriced premium - really is nothing more than a speculation tax that Wall Street levies on the greedy, those who think they can time the market and capture stock moves by purchasing calls and puts. Think of the US markets as a large casino; Wall Street is the house, the casino operator. Wall Street happily sells overpriced options to speculators, and like any gamblers, they win sometimes. When you are writing covered calls the way I do (selling high premium), you are trading with the house - not trading against Wall Street. I'm just elbowing my way into the game and betting with the house.

Implied Volatility and Covered Call Writing

What does this have to do with CallWriter, or covered call writing? There are a lot of different approaches to covered call writing (future newsletter topic). The CallWriter approach is to identify the universe of stocks offering the highest call premium and group them by highest return onto our covered call lists. We find the highest returns and select trades from among them. So we are always writing calls with high levels of IV.

We're selling call options to speculators, who pay through the nose for them. We pocket the high premiums. Is this dangerous? Well, it has not historically been dangerous for us. Certain stocks can move very significantly, but the art of covered call writing is to write calls when premium is high on stocks you like and are willing to own and that have the least likelihood of selling off on the event horizon. That is, you have to be disciplined in trade selection.

Trade selection really is not that difficult for the covered call writer. Much of the education on the CallWriter members' site is devoted to the selection process. It's as much knowing what to avoid as what to look for. It is not random, and not difficult. More on this in future issues and TeleLab calls...

This issue's Question and Answer:
Volatility Skews

Question:  Sometimes volatility will really be skewed and one call option on a stock will be dripping with high implied volatility. Have you found a really pronounced volatility skew in the calls to predict the stock's direction?

Answer:  No, for the reasons indicated in the article above. All call series on the same underlying stock for the same month should - theoretically - have the same level of implied volatility (IV). But this rarely happens in reality. While some IV levels of different strikes may be close, they will rarely be the same. Different strikes for the same month can vary wildly. For example, an expensive OTM call may have sky-high IV, while the ITM call has very little time value and thus has a very low IV. I've seen the biggest return, and thus the highest IV level, in a deeply ITM call. The ATM call frequently has the highest IV, just as it typically carries the highest covered call return.

A persistent belief in the trading community is that the strike for a particular month with the highest IV is the one most predictive of where the stock is going. But I have not found that to be true. The strike with the highest IV merely indicates some consensus among speculators as to where they think the stock is going. And sometimes they will be right; more often they are not. If you are a contrarian, like me, you tend to believe that the crowd is wrong, and go the other way. So for a contrarian, the lowest-IV strike should be investigated.

I have not made any systematic analysis of volatility skew, but others have. If getting rich was as simple as buying the call or put strike with the highest IV, we'd all be doing it.

Good luck and good trading!