Monday, August 31, 2009

The Over-Write

Viewed most of last week's Options Action and I've got another over write to kick around. For those of you that missed last Monday's Options Action post, check it out here. For those not up to snuff on options vernacular and the sometimes confusing synonyms that abound in the financial markets, covered calls are oft times referred to as buy writes or over writes. Remember a covered call consists of being long 100 shares of stock (or increments of 100) and short a call option.

Covered Call = By selling a call option I'm obligating myself to sell 100 shares of stock. That obligation is "covered" by a long stock position.
Buy Write = I've bought shares of stock and am writing (think selling) a call option against my stock position
Over Write = I've bought shares of stock and am writing a call option with a strike price above (over) the current stock price.

Because we still find ourselves in an environment where options are overpricing the volatility we're actually realizing day to day, another covered call was suggested. To setup the trade the following was said (I'm paraphrasing):

"Even though implied and realized volatility are lower than they've been in a while, it doesn't mean it's not a good time to do an over write strategy in the right name."

To that I say, yes and yes. There's no doubt the VIX (which I'll use as a proxy for implied vol across the board), and the day to day moves we've realized recently have been much less than 3 to 6 months prior. But as Adam Warner at DailyOptionsReport reminded in his recent post on AIG:

" Options volatility [read: implied volatility] is only relevant in comparison to the volatility of the underlying. No one knows the volatility of the underlying going forward, so the best clue around (barring an expected news event) is the volatility of the recent past [read: historical volatility]."

VIX could be at 10%, an extremely low reading to be sure, and SPX options could still be overpriced vs. realized volatility. For example, we could buy SPX straddles at 10% volatility, guessing that options were underpriced, but if the SPX only realized 5% through the duration of that SPX straddle trade we'd probably have lost money.

Back to Options Action- the suggestion was selling an Oct. 40 call on National Oilwell Varco (NOV) for $1.50. From a volatility perspective I like this better than the NSC suggestion from last week. Take a gander at the vol chart:
Current IV sits around 47% with 30 day HV at 43%. As you can see, both are the lowest they've been for the last 6 months (were I to display a 1 year chart you'd see they're the lowest in about a year). But as mentioned previously, although they're low, IV still overprices recent realized vol. Now you may quibble that there's not a huge premium of IV vs. HV, but I'd argue there's certainly enough to cause me to agree with selling options as opposed to buying.

I'll expound on the benefits of over writes in subsequent posts-