Income investors can write (i.e., sell) call options on stocks that they currently own to increase portfolio income. Writing covered calls takes advantage of the fact that most options expire worthless. When that happens, the options seller profits at the expense of the options buyer.
Options prices are determined by several factors, including the stock's price, the exercise price of the option, and the amount of time until the options contract expires. These can all be easily determined, but one factor that is more difficult to assess is volatility.
Volatility refers to how much a stock price moves. A stock that gains or loses an average of 2% a week is considered to be more volatile than one that moves only 0.5% a week, on average. More volatile stocks have a greater chance of moving to the option's exercise price, and this makes options on more volatile stocks higher priced than options on low-volatility stocks.
Different formulas are used to calculate the volatility of options and these calculations are updated frequently. While these formulas are very complex, we can get a general idea of whether volatility is high or low by looking at the CBOE Volatility Index (VIX).
The VIX is commonly called the "fear index" because it tends to rise as the market falls and traders become more anxious. On the other hand, when market prices rise, the VIX tends to decline. For example, In the first week of January, when the S&P 500 gained about 4.5%, VIX lost almost 40%. We can see this inverse relationship in the chart below that compares VIX with the S&P 500 index.
Unfortunately, there is no way to forecast turning points in stocks based solely on whether VIX is high or low, as the index tends to remain low for extended periods, just as it can remain elevated for great lengths of time.
Rather than trying to time the market with VIX, income investors can use it to time their actions in the options market. As a general rule, when VIX is low, options prices will be low and there is less benefit to writing options. When VIX is high, traders should take advantage of increased options prices by selling contracts.
Of course, with sufficient work, there will almost always be options that move against the general trend, just as there are always some stocks that go up in a bear market and some losers even in the strongest bull market. But traders can monitor the VIX to identify the best times to sell options, using the 26-week moving average as a guide.
The chart below shows that VIX is itself a volatile indicator.
This VIX is currently trading at 13.6, within 2.3% of its 52-week low and well below its five-year average of 23.7. At this level, VIX is extremely oversold, and could be due for a move higher, therefore making selling options more attractive.
In fact, ti has actually fallen to a value near its current level four times in the past two years. Each time, it bounced at least 10% higher within three weeks. Even when VIX remains low for several months, it makes frequent moves up.
Action to Take --> Traders should prepare for a potential increase in VIX by finding stocks they would like to write options on. This opportunity could occur before the end of January.
This article originally appeared on ProfitableTrading.com:
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