Good day Rookie Bloggers, Last week we talked about how we typically defend our positions when markets turn and volatility spikes. The traditional method of buying puts can come with a host of problems when volatility gets jacked up to metoric levels. Our discussion led to trying to turn volatility onto our side instead of working against us. We talked about the ITM Covered Call strategy and we will delve into that further in today’s blog. Before we get into the meat of the ITM Covered Call strategy we will talk about a couple of other things that can stave off the problems from exploding volatility.
When volatility strikes we can eliminate the effects of it by using stock to maneuver through the changes but that really doesn’t help most folks for a couple of reasons. First off, when volatility is rising and stocks are falling this can cause a cash crunch for some folks if they are overleveraged even if only slightly. So, having this lack of cash makes it hard to offset the damage of falling equity because the lack of buying power is going to limit the amount of stock that can be sold short as the buying power that is available is being reduced with every drop in price. Secondly, the benefits of leverage from options are lost when we use the stock. So as Churchill once said, “with great power comes great responsibility.” If we modify that slightly it can fit with our theme, “with great leverage comes great volatility.”
So, if stock can’t really help us when it comes to combatting volatility then what can we do? We are really kinda stuck with using options because the leverage can really help offset some vicious swings in price but as we explained last week this is fraught with its own issues.
However, all is not lost as we can do a few things that will take the sting out of using options with huge volatility. We talked about the ITM covered call last week and this can be a good choice but there are other ways to deal with this and using spreads, which is essentially buying one option and selling another at the same time can offset the effects of volatility, at least to a certain degree. The Bear Put spread can be reasonably effective in this manner. It is a debit trade meaning that you are putting out cash up front but it does give you access to that leverage that we are looking for in the options world. This debit spread has its faults as well but at least it gives one a chance at saving some of the portfolio damage that takes place inevitably when the fall starts.
If spreads aren’t your thing but you have been introduced into the world of covered calls then you can modify them slightly to fit the needs of a falling equity as opposed to the usually bullish posture that we look for in an OTM covered call. The ITM takes in both intrinsic and extrinsic value and it is the intrinsic that saves some of the declining balance of the equity.
Let’s take the example of XYZ stock. Let’s say you bought XYZ stock at $50 per share and the market starts to fall and the volatility spikes. This could send the cost of a put option into the stratosphere depending on how big the decline is and no one wants to overpay for protection as I mentioned in the previous blog post. So, instead, we can look at where the next support level is and build an ITM-covered call that can give us the intrinsic value that will offset some of the declines. Let’s say there is a support level at $45. If we went for the ITM $45 call option and the price of XYZ was at $50 then there would be at least $5 of intrinsic value in the option and a little bit more for time decay and volatility. Let’s surmise that we sold the $45 ITM covered call for $5.50. If the stock were to drop to $45, we would lose $5 per share in stock price but we gain $5 in intrinsic value and therefore this could stem the tide of the falling equity. At the same time, we would be gaining the extrinsic value as time passed and therefore it is possible that we could still profit from the trade under these particular circumstances. In real trading, it is not usually this clean but the concept remains the same.
What we have accomplished here is that we have protected our stock position down to $45 by selling an option as oppposed to buying an option. When selling we get to keep the premium over time if things go our way but by buying time acutally hurts our trade if things do not go our way far enough, fast enough or the dreaded volatility offsets the actual movement of the stock. I have seen this many times and it is never fun!.
So, if you are facing a situation where the volatility has the potential of messing with your position be sure to view the trade from a different angle and you may find a way to get what you need by doing the oppositie of what you might think is the best course of action.
In the blog next week we will take a look at an actual example of an ITM covered call to see how they play out.
Coach “Old Money” Holmes