Cue the Tenors

Picking Terms for Covered Calls

Created with DALL-E

Setting the Table:

• If you didn’t show up to trade this week, don’t worry, we’re in exactly the same place we started on Tuesday morning. If you did, I hope you sold condors. Two days of dips were followed by two days of picking those back up. Futures are up 50 gentle basis points heading into the open.

• As discussed in the Trading Opportunity posts earlier this week, the relative dispersion in the market is what we’re focused on going through the next month, particularly with tech earnings starting in earnest next week. 

  • DSPX measures the difference between the implied “VIX” calculation of the individual components and the index. Diversification is what brings the index average lower, and higher DSPX values predict a wider range of outcomes for single stocks.

  • There is a good deal of cyclicality to this - earnings announcements drive individual results - but it's also a good barometer for when vol markets set expectations of more movement at a stock level  and the notion that we’re rolling into a “pickers” market, where under/outperformance increases. 

  • Compared to when we highlighted this 2 weeks ago, implied forward dispersion continues to tick up.

    

  • For a deeper dive into the DSPX index, check out our previous post “Taming Wild Components” 

• Today marks the largest expiration for individual stocks. While not necessarily true for indices (that’s the end of the calendar year), Monday’s sheets will look much cleaner for all market participants. Don’t confuse this with a greek shift though, by definition anything that’s rolling off today has already spent its lifetime being hedged and there are only a few strikes of gamma - same as it ever was. There’s no gotcha on Monday. Expiration just means more capital that isn’t tied up in minimums and far ITM/OTM options. 

Identify:

• Covered calls are the first options trade we all learned. The simplicity often belies the effectiveness of this strategy. The trade is intuitive and attractive at a gut level - if it goes down I have a little more cash than otherwise, and if it goes up and hits my target I’m happy for some gains. It fits well as a step up from equity ownership, and underlying selection is driven by many of the same factors. Most importantly, a covered call also harnesses two of the most powerful premia in investing.

• The equity risk premium (ERP) is the idea that over time the equity markets will reward long term stock holders with an additional premium over the risk free rate. Measured versus treasuries, over the years this figure is somewhere around 4-6%. The key here is the term, because the price you pay for this premium is volatility - your balance might not always be there when you need it. 

• The variance risk premium (VRP) is the corollary in options space - the idea that writers of options have a certain edge because implied volatility is mostly over the realized historical volatility. 

• When you sell a covered call, you are capturing both sides of the VRP spread because you are long the realized vol through the stock leg, and short the implied through the option. Path dependent of course.

• The gotcha that pure volatility traders will point out about a covered call is that you’re giving away the right tail (upside), but accepting the left one (downside). It’s a complicated question whether that volatility level is the right price. What’s far more important for individual investors is deciding whether the risk profile is appropriate for them, and choosing underlyings that fit their objectives. 

• High dividend yields, low volatility, resistance levels, and momentum can all be indicators for traders of specific temperaments.