Using Implied Volatility to Determine Safe Strikes for Portfolio Overwriting: A Real-Life Example with PayPal Holdings, Inc. (Nasdaq: PYPL) – May 23, 2022
Portfolio overwriting is a covered call writing-like strategy. We use it with our long-term buy-and-hold portfolios in non-sheltered accounts with the objectives to generate additional cash-flow while still retaining the shares. Share retention is a required objective to avoid potential negative capital gains tax issues. In my books and online videos, I suggest a 6% – 8% annualized return target that can be adjusted to meet our strategy goals. In this article, I will provide another approach to selecting the out-of-the-money covered call strikes to meet both goals using implied volatility and projected trading range over the course of the contracts.
Strategy protocol
- Locate an elite-performing stock or ETF
- Access the mean implied volatility for that security (cboe.com, ivolatility.com, all brokerages)
- Convert the annualized IV stat to a contract specific IV (BCI Expected Trading Range Calculator) to generate a projected trading range
- Use the upper end of that range to select the most appropriate strike
- Selecting a strike at the upper end of the IV-based trading range will result in an 84% probability of success trade
- Access an option-chain to view option premiums
- Use the BCI Trade Management Calculator to confirm the returns meet our stated goals
PYPL Implied Volatility: 33.07
PYPL trading range calculations: BCI Trading Range Calculator
The spreadsheet shows a projected trading range between $269.81 and $326.33 with the current price at $298.07. For portfolio overwriting, we will check the strikes near $326.33.
***The formula inherent in the spreadsheet is located at the bottom of the screenshot in red.
Option-chain data for 1-month August 20, 2021, expirations
We will use the published bid prices for the $325.00 and $330.00 strikes.
PYPL calculations using the BCI Trade Management Calculator
- The $325.00 strike generates an initial annualized return of 10.82%, with an additional 9.03% of upside potential
- The $330.00 strike generates an initial annualized return of 8.49%, with an additional 10.71% of upside potential
- If our target annualized return is 8% – 10%, both strikes will meet our goals. The deeper out-of-the-money $330.00 strike is safer and still meets our time-value stated goal
Discussion
Implied volatility can be used to establish a trading range specific for every option contract period. When portfolio overwriting, we establish an upper end of the trading range and check to make sure that the targeted strikes will meet our stated strategy income goals.