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Options Calls: To Write, or Not to Write?


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

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.
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