Option Writing In A Low Premium Environment (14:04)

By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 3, No. 23 on December 8, 1994. 

In theory, an option strategist will adjust his strategies to reflect the opportunities that the marketplace is offering. For example, if volatility is low, then volatility buying strategies are preferred. Or, if volatility is high, then option writing strategies are preferred.

However, not everyone is able to have so much freedom in the strategies he employs – or he may not want that much freedom. For example, in a managed account format, most advisors and clients agree on what strategies will be used, and thus the list of strategy choices is limited to that. Such an arrangement makes sense because it’s what the client feels comfortable with. Similarly, even when one is managing his own money, he may be interested in only a limited number of strategies – probably for the same reason: he feels most comfortable with those.

In our seminars – from the most advanced and detailed to the shortest and most elementary – we stress that one should only trade strategies with which he or she feels comfortable. This, I feel, is of psychological importance, for if you don’t really believe in what you’re doing, or if you don’t feel comfortable doing it, you’ll probably lose money in that strategy, even though others might be employing it profitably at virtually the same time.

Hence, for these reasons – and perhaps others – many traders are constrained in the option strategies they use. And so it sometimes evolves into a situation where one is looking for option writing strategies in a low premium environment.

These strategies would predominantly be covered call writing or naked put selling (which are equivalent strategies – meaning they have the same profit and loss characteristics: limited upside potential and large downside risk). However, option selling is also involved in spread strategies. So, those strategies should be included in this discussion as well.

Covered Call Writing/Naked Put Selling

There are a couple of things that a writer can do, but first and foremost he should not lower his entry criteria. In other words, if one is using expected return as his ultimate selection criterion, then he will generally find very few potential covered writing candidates actually pass the “expected return” test when option premiums are low. However, that should not be an excuse for lowering the criterion. A positive expected return should still be required, and it should still be in the general range that one considers acceptable.

For example, in our covered call writes, we normally require an expected return of 12% (annualized) for a covered call write, based on executing the write in a cash account. In a higher-premium environment, we might find that so many writes pass that criterion, that we would raise the bar to 15% or 18%, say. But we won’t go below 12%, no matter how few opportunities are available in a low premium environment.

Assuming that some acceptable opportunities do exist, first and foremost on that list we would look for the shortest-term writes that make sense. This prevents us from committing too much capital to a low-premium write for an extended period of time. Eventually, premiums will begin to increase again, and so we’d like to complete our previously-established low-premium writes and be able to move into higher-premium ones.

One might suggest – on a theoretical basis – that, if premiums increase at a later date and thus higher expected returns are available, one could merely close out his existing positions and establish new ones. In practice, few traders would do that, even if commission costs were very low.

The converse approach would be to lengthen the horizon of your covered writes (or put sales) when premiums are especially high. In that way, you’d be getting an unusually favorable return and extending it for as long as possible.

This concept of shortening your horizon when returns aren’t as favorable and lengthening it when returns are very favorable is not unique to option trading – it applies equally well, for example, to bond investments. Shouldn’t we all have bought 30-year Treasury Bonds when they were yielding 16% or more in 1982? (And, by a similar argument, shouldn’t we be reluctant to buy 30-year bonds yielding 4% now, rather preferring something of a much shorter maturity?).

What else can be done? Look for more special situations. There are a couple of ways that one could interpret that statement. First, one could look for newsrelated writes, preferring to inject a modicum of newsrelated analysis into the “equation,” rather than just relying solely on the mathematics of expected return. Even in this low-premium environment, we have seen options get expensive on stocks right before earnings are to be reported. In many, many cases, the stock didn’t move much. Two recent ones are NVDIA (NVDA) and Netease (NTES). If things don’t go well, and bad news does occur, one could expect that the option implied volatility would shoot upward as the stock dropped, and one might be able to roll down and out to a later expiration month during the time that premiums are expanded.

Although the following can only be done once a month, both of the above “methods” can sometimes be employed by finding covered writes that are very near expiration, yet still offer a high return. The following example shows what this means:

Example: on February 8th, Medco Health (MHS)
was trading at 42.50. The Feb 40 calls (MHSBH)
were bid at 2.95. Thus a covered call write could
be established for 45 cents over parity, and that
write would have 10 days until expiration (8 of
which were trading days). This meets the rate of
return, as long as commissions are small. Earnings
were due to be reported on February 15th, just three
days before expiration.
As it turns out, MHS’ earnings were acceptable,
and the stock stayed above the striking price until
expiration.

Finally, there is one other thing that option writers can do in a period of low premiums: step aside to a certain extent, raising cash and reducing your exposure to the market. The cash can be put back to work when premiums expand once again or – if conditions permit – when isolated cases of high expected return do surface.

The thing not to do is just to keep on doing the same thing because it used to work in the past. We have talked about this in a previous newsletter, but perhaps it bears repeating once again.

Example: an investor began writing covered calls in
the second half of 2002, when premiums were
outstanding and when the major stocks began to
bottom. Returns were excellent, and so the same
stocks were held and written against over the
course of the next couple of years. By now (2005),
that writer has become complacent. Since things
have worked out so well in the past, he’s likely to
continue to sell calls that don’t make sense. Take
  GE, for example:
  GE: 35.30
Sept 35 call: 1.75
Is this a “good” covered write? One can expect to
collect 44 cents in dividends between now and
expiration, as well as the premium. These are the
relevant volatilities:
  Implied: 14.7%
  100-day historical: 15%
  50-day historical: 14%
  20-day historical: 11%
So, using a 15% volatility for GE in the expected
return calculation, this has an expected return of
only 3% on cash (less on margin) – well below any
reasonably acceptable levels. Hence, this is not a
good covered write – you are not being adequately
compensated for the risk with this low premium
(alternatively, you are giving away too much
upside by selling this low premium).

Spread Strategies

Spread traders are option writers, too – even though they are also option buyers. During periods of low premiums (or low volatility), spread traders should be aware of adjustments that they, too, might make in their strategies. For example, some traders prefer to frequently execute bulls spreads. If one is establishing these with upside profit potential (i.e., buying an at-the-money call and selling a farther out-of-the-money call, as opposed to using out-ofthe- money bull put spreads – credit spreads), he may be giving away too much by selling that out-of-the-money call. Perhaps he would be better off just buying the long call, accepting that risk, and forsaking the hedge of the bull spread – at least until option premiums once more return to “acceptable” levels.

Also, one should concentrate on spread strategies that benefit from a potential rise in volatility (backspreads, say, or at least calendar spreads) as opposed to those that are hurt by such a rise (ratio spreads, for example). Ratio spreaders are sellers of excess options (i.e., more than they buy) so they are especially vulnerable to a rise in implied volatility. Hence, they should probably curtail that activity altogether in times of low volatility.

Summary

Whether you write or spread, when volatility is this low, don’t be lulled into doing the “same old thing.” Make adjustments or curtail your writing activities.

This article was originally published in The Option Strategist Newsletter Volume 14, No. 4 on February 24, 2005.