Portfolio Overwriting in High Implied Volatility (IV) Markets – October 10, 2022
One of our covered call writing-like strategies is portfolio overwriting. The strategy involves selecting deep out-of-the-money (OTM) strikes that will generate lower returns than traditional covered call writing but also decreases the likelihood of exercise (our shares being sold). The returns will still be significant when annualized, while still enhancing the probability of avoiding exercise and retaining the shares.
Basis of strike price selection
Since share retention is a priority goal, we will select only out-of-the-money strikes with Deltas between 0 and .50, the closer to “0” the better. Next, we must determine what our annualized return goal is over-and-above typical share appreciation and dividend income. Let’s say our portfolio is appreciating 6% per year plus an additional 2% per year from dividend distributions. We may set a goal of an additional 6% per year for a total average annualized return goal of 14%. If we are using Monthly options, that would compute to 0.50% per-month. If we are using Weeklys, it would result in a 0.12% weekly initial time value return goal.
Can we set our monthly goal from 1/2% per-month to 1 1/2% in high IV conditions?
This is tempting but the strike in normal market conditions that generates 1/2% is quite different from the strike that will generate 1/2% in high IV conditions. We must keep in mind our stated portfolio overwriting mission of retaining the shares.
Option premiums in high IV markets
The time-value component of option premiums is directly related to implied volatility. If IV increases, as it did in April of 2022, the corresponding option premiums will also rise.
Delta in high IV markets
Since the expected trading range for high IV securities is much greater than that of normal market conditions, the Deltas of the corresponding strikes will also increase as the probability of expiring with intrinsic-value is enhanced. Therefore, the strikes must be adjusted higher to preserve stated goal of a low probability that the strike will expire ITM.
Real-life example for a 1-month expiration for Microsoft Corporation (Nasdaq: MSFT): ($272.99)
- To achieve a return of 1 1/2% of $272.99 or about $4.09 ($4.00 brown cell), we would look to the $295.00 strike which has a Delta of 24.88% (pink cell), about a 25% probability of expiring ITM and resulting in exercise with no exit strategy intervention
- To achieve an initial return of 1/2% of $272.99 or about $1.36 ($1.12 and $1.59 in the yellow cells), we would look to the $310.00 and $315.00 strikes which have Deltas of 11.77% and 8.97%
- Our investment decisions and trade structuring depend on these 2 factors
Discussion
Portfolio overwriting has 2 main stated goals. We seek to generate lower but significant annualized returns while establishing a low probability of the option expiring ITM. In high IV market environments, we may be tempted to use similar strikes we would have selected in normal market conditions, but Delta will play a role in making such decisions higher risk.
Author: Alan Ellman