Covered Calls: A High-Volatility Crutch?

by Tyler Craig | August 16, 2011 1:02 pm

Covered Calls: A High-Volatility Crutch?

The recent volatility rampage presents yet another example of the counterintuitive nature of covered calls and volatility.  Since this long stock/short call combination involves selling options, it is by nature a short volatility play. 

Conventional wisdom says covered calls are a more appealing strategy in times of heightened volatility as the premium received is elevated. After all, selling an at-the-money option for $2 certainly appears superior to selling it for $1. When volatility is depressed, option premiums shrink in value, thereby offering less potential reward to option sellers.

With this in mind, last week’s pop in the CBOE Market Volatility Index, the VIX to the upper 40s must have been a golden opportunity for covered-call players right?

Not necessarily.

Let’s add one more bit of analysis to the mix: the effectiveness of covered calls under different market conditions.  Outright stock ownership trumps the covered call when the market rises aggressively.  The covered call holds the upper hand in mildly bullish, neutral, and mildly bearish environments.  The covered call is also superior in aggressively bearish environments, but cash is even better. 

In sum, when expecting either a large increase or decrease in the market, covered calls aren’t your best bet.

As Adam Warner states in Options Volatility Trading, “…options volatility does not price in a vacuum.  It represents real market expectations for actual volatility.”  Consider the most likely outcomes when the VIX has entered the stratosphere.  Either stocks are in the process of plunging and likely to continue, or they are on the verge of a monster snapback rally.  In the former case, cash is king. In the latter, you’re better off owning stock outright.

It’s an oversimplification then to state that covered call players relish times of heightened volatility.  When you take into consideration the actual behavior of the market, the ideal environment usually comes when volatility is depressed and option premiums are smaller.

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