Calibrating for Skewness

How to think about covered call allocations in your portfolio

Setting the Table:

• Vol is up 33% in the last ten days! Now a thirty day ATM reading of 15% or a VIX of 17 is hardly markets in turmoil, but it has woken up investors lulled by a sleepy summer. Saying it’s up some huge percentage isn’t as relevant as understanding that annualized implied variance has risen by 3-4 points. More, but not a LOT more. 

  • Compared to the slow grind up we’ve had, Tuesday dropped and kept going. Yesterday was a strong rebound that failed and turned back lower. As things start churning, the path the market and pricing inputs take on a day to day basis gets significantly longer. 

• When vol perks up, so do covered calls and cash puts. COVC30  is up about 30 bps in the last ten days for both QQQ and SPY.

  

  • That means a good deal more cash to collect today. On SPY, 30 bps of additional premium is $162 in your pocket for every contract on the 30 day option.  

  • It also means there is more distance for the same delta - the 30 delta call closed yesterday $14 out of the money (2.6%), whereas on July 15th it was $11 (1.95%). 

  • Here’s another plug about strike listings - on July 15th SPY only had the $572 and $575 strikes listed. While now those dollars have been filled in - even thirty days out you were forced to choose between the 28 delta and 33 delta. 

• But what happens to the position if you traded a week ago? That would have been very reasonable to trade on a serial expiration! (See - Splitting Apart Strike Scores).

  • Imagining you had the foresight to shade your delta higher, and sell the $572 strike at $3.70 - it’s now only worth $0.38. Assuming this was Bought/Written, the PnL on the trade is down $22.76 on the stock, and up $3.32 on the option - a net loss of $19.44 per share. 

  • Further, the position has materially changed - the delta of that short call has plummeted to 5. Don’t forget the short gamma - covered calls get longer deltas as stock goes down.

  • What do we do next? In this week’s Portfolio Design, we’ll analyze how to manage and think about portfolio allocations with covered calls. 

  • Sitting at a market maker desk, the arithmetic is simple. Long 100 shares of stock, sell a 30 delta call, the position is now long 70 deltas. To get delta neutral, sell more calls, stock, or buy a put. Do more of this as stock goes lower. The goal is to be flat. For options investors, the calculus might not always be so simple…