October 6, 2005

Low Volatility - Call-Writing Heaven
by John Brasher, CallWriter Publisher

There has been a lot of talk recently about current low levels of market volatility and what it means for traders and investors, market timers in particular. I think financial writers are missing the point. Today's lack of price volatility is a good thing for covered call writers. Here's why...

By some measures, the market is pretty flat and mostly has been for a while now. Volatility - meaning historical volatility of actual stock market prices - is at the lowest levels of the past decade. The only surges in volatility have been due to external (non-market) events such as Hurricane Katrina, but even these have not been impressive in range and have not lasted very long. The market has pretty much shrugged them off. So we have a flat market that, as one writer put it, is like watching paint dry.

Low market volatility is pure hell for market timers, those who read the tea leaves and speculate on price movements through buying puts and calls or buying stocks. Stock prices just won't cooperate! Why is volatility low? In simple terms, there is not a lot of interest in the market. There are not enough buyers to take the market up, but enough to keep the bears from driving it down. Volatility is a cyclical thing, and right now it's low.

So if you are a put or call buyer, life is frustrating. Those who construct debit spreads (bear put and bull call), in which a strike is bought close to the money and a further OTM option is sold, are also watching the market leave them high and dry. The good thing for market timers (the only good thing) about a low- volatility market is that it depresses premium, which is further depressed by low interest rates. This makes options cheaper. But if long option positions and debit-spread positions are not working because tired stocks won't move sufficiently, doesn't this really just mean that the losses are smaller and the stock gains are smaller?

One writer recently took the opportunity to knock covered calls and naked puts, reasoning that with premiums so razor-thin, it makes little sense to write covered calls or naked puts now. (Remember, a covered call is just a way of creating a synthetic naked put and has the same risk/reward profile.) But this logic fails entirely with me, for several reasons. First, when you have the means to find the highest-returning covered call trades, as CallWriter does, premiums are not razor thin. In fact, they can be pretty doggoned hefty. Second, while premium generally is not what it was 18 months ago, and is far smaller than during the great bubble market that ended in March 2000, there still is some fine premium out there. Third, low volatility means less risk, at least statistically, in writing covered calls, since there is less risk of the stock dropping during the short window while the trade is on. Let's see, premium is smaller, but volatility risk is smaller. Hmmm... sounds like they balance out, doesn't it?

Let's take a look at some of the covered call plays featured today on CallWriter's Real Time Lists™ and see if premium is really all that razor thin. I've culled some interesting trades from our October lists this afternoon (roughly 2:00 pm ET) to provide some examples. Keep in mind that October equity options expire on 10/22/05, which means there are only 16 days until expiration:

The information presented above is very abbreviated, and only shows a part of the data contained in the Real Time Lists™, but you can clearly see the potential returns. Now these are not goofy little low-volume stocks that skate all over the place!! These calls expire in 16 days, which is only half a month. So to get the true monthly return, you double the stated return. Thus a 3.2% return for 16 days really is over 6% for a month! You are completely welcome to view it differently, but in my book 6% a month is kicking!

Low volatility means lower call premiums, yes, yes, yes, but it means lower risk - at least statistically; you still have to use due care (which CallWriter teaches) in selecting trades. But don't be misled; there still is some good premium out there. You just have to be able to find it. My colleagues and I learned long ago the deep value in having constantly-updating lists of the highest covered call returns. That discovery was the genesis of CallWriter. I can only suppose that the writers mentioned above have no access to our Real Time Lists™. Maybe you don't either, and if not, I suggest it's time to give us a try. You might find you like the idea of clipping coupons in this lousy, mean, boring, old low-volatility market.

Question:  Which do you prefer for trading, simple or exponential moving averages?

Answer:  I primarily use the 14- and 50-day averages for the short-term horizon. In my experience, simple or exponential usually doesn't make much of a difference on this time horizon. Exponents of the exponential feel that crossovers don't lag as much when using them, but if you overlay both a simple and EXP 50-day average over a chart there usually isn't much of a difference. I typically use the simple, because it is based on raw, unworked data and don't find a marked advantage with the EXP, but that is just my preference, and no one will go wrong using the EXP.

Good luck and good trading!