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Options Theory: Combating Volatility with Covered Calls

November 8, 2018

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Nothing like a monster “V” shaped reversal to get the juices flowing, am I right? Count me among those suffering whiplash over the market’s death-defying whoops and whirls of late. Yesterday was particularly annoying for those short delta toting traders like me.

Since volatility is fresh on my mind, I wanted to highlight how covered calls can be used to combat these wild gyrations. It’s a tactic we use every single month to reduce the range of outcomes in the Bear Tamer system. When a stock trader learns how to control volatility it becomes much easier to stay the course when their beloved stock holdings get taken behind the woodshed.

The Delta Perspective

Remember, the covered call consists of owning 100 shares of stock and shorting one call option. Suppose you sold a 30 delta call. The resulting position would look like so:

Long 100 shares stock: Delta +100

Short 1 OTM call option: Delta -30

Net Delta: +70

Notice how the addition of the call to your stock position reduced your initial directional exposure by 30%. That means for the first $1 move you will experience 30% less volatility in your position. How many readers would have liked to have seen that type of reduction in their stock portfolio’s losses last month?

Think of all the benefits associated with this dampened fluctuations.

  1. Less emotion
  2. Easier to invest for the long run
  3. Easier to ignore the day-to-day market drama
  4. Better sleep
  5. Happier life

Now, let’s consider how the covered call would look after the stock dropped a considerable amount (like last month).

Long 100 share stock: Delta +100

Short 1 (now way OTM) call option: Delta -5

Net Delta +95

As you can see, a drop in the stock price would have chipped away at the hedging value provided by the short call. Eventually, the call will provide no benefit at all. So what do you do?

Close it and sell another call that has a delta closer to 30. That should reduce the net delta from +95 back to +70 thus putting you back in a position with 30% less fluctuation than the straight stock owner.

Rinse and repeat.

I suspect proactive traders rolled their covered calls once or twice over the past six weeks due to the massive price fluctuations.

What If Prices Skyrocket?

While short calls succeed in reducing your loss on the downside, they also cap gains on the upside. The volatility dampener works in both directions. As just outlined, when prices drop short calls lose their hedging effectiveness thus requiring rolling to new calls to re-up the protection.

When prices rise, short calls can become so effective at reducing the volatility that they eliminate any further potential gains. In contrast to the previous example let’s see what might have happened if you bought a stock at the market low last week right before the sharp 8% jump. At this stage, your short call may be deep ITM.

Long 100 share stock: Delta +100

Short 1 (now deep ITM) call option: Delta -95

Net Delta +5

You’ve made money, sure, but the rate of gains was notably less due to the short call. And at this point, it’s almost entirely cutting off your profits.

How do we fix it?

Roll to a new, lower delta call.

Rinse and repeat.

If you continually sell calls against your stock holding and adjust as the call delta approaches zero or 100 you will succeed in reducing the volatility of your stock holding and thus make it easier to be a long-term wealth builder.

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