Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Options Calls: To Write, or Not to Write?

By

Best plays may be in small, volatile, illiquid firms.

PrintPRINT
It's the eternal options question: When, and on what, should you write calls?

CXO Advisory highlights a recent academic study on the subject:

"On what kind of stocks can covered call writers obtain the best returns? In their July 2009 paper entitled "Cross-Section of Stock Option Returns and Individual Stock Volatility Risk," Jie Cao and Bing Han investigate how delta-hedged stock option returns vary with volatility risk. They measure this return as the change in value of a self-financing portfolio that is long the call and short the underlying stock, rebalanced daily so that it is not sensitive to stock price movement.

"They assume trade execution at the mid-point of closing bid and ask quotes. Using returns for about 160,000 at-the-money delta-hedged option positions initially about one and half months from maturity (and held to maturity) for over 5,000 underlying stocks during 1996-2006, they conclude that:

"On average, delta-hedged option returns are significantly negative, and they decrease systematically with both total and idiosyncratic volatilities of the underlying stock. For example, held to maturity, delta-hedged call option positions lose on average 0.49% (4.32%) of the initial stock (call option) value.

"Writing covered calls on high-volatility stocks earns on average about 2% more per month than selling covered calls on low-volatility stocks. This spread is significantly higher for small firms, low-priced and illiquid stocks and for options with high bid-ask spreads.

"In addition, returns from writing covered calls are:

1. Higher for past winner stocks than past loser stocks.

2. Decrease with option open interest.

3. Increase with the difference between realized volatility and at-the-money implied volatility.

Assuming effective option bid-ask spreads of 50%, 75% and 100% of the quoted spread reduces the average difference in monthly returns between covered calls on high versus low volatility stocks from 2.33% under study assumptions to 1.25%, 0.73% and 0.22% respectively.

"The 0.22% average monthly return is not statistically reliable. In other words, only traders who can achieve relatively low options market trading frictions (such as option market makers) can reliably capture the extra volatility risk premium for high-volatility stocks."

Long story short, your best plays are in "small, high volatility, illiquid past winners."

In other words, a spot that's already popped and you have trouble getting good fills.

The already-popped part is fine, though I would suggest errors there can prove disastrous. How did it work out writing calls in Juniper (JNPR) in 1999 after the first doubling? The study depends on a constant delta flattening. As we've noted recently, that's certainly something you can do, but it's mentally very tough to keep chasing higher. Fear of Major Whipsaw kicks in.

The illiquid part though, that's really Ivory Tower stuff. You really can't get good fills in those names.

I do find the whole concept interesting though. If you told me the study and asked for a prediction, I would have guessed the best options selling results were where you'd least expect them. Like the Coca-Cola's (KO) of the world, where options look dirt cheap, but the stocks themselves barely budge.

But on the flip side, I do find that shorting puts into mini-weakness on strong names is a good strategy, and this would seem to at least to bear that out on some level.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE