Earlier this month, I talked about profiting from elevated volatility using two little-known exchange-traded notes (ETNs).
But if you missed that article, don’t worry – because an even juicier opportunity lies before us today.
The VIX, which measures volatility on the S&P 500, has remained above average since the August flash crash. That’s bad news for stock traders, but great news for options traders.
You see, when market fear drives volatility, options prices rise, and buying becomes unattractive. On the other hand, options sellers happen to do very well when the market gets choppy.
Baby, Don’t Fear the Option
For many investors, “option” is a dirty word. But most people fear options because they don’t understand them. When used correctly, these instruments can generate reliable income.
Now, we also know that the best investors buy low and sell high. But when options prices rise with volatility, sellers cash in on fear by flipping the script on that mindset. They sell high and buy low. As you know, the VIX measures implied volatility on the S&P 500. Volatility is one of the main factors used to determine an option’s price, which makes the VIX an important technical indicator for options traders.
Best of all, there’s a safe and easy way to do this: covered calls.
A Win-Win Strategy
Covered calls can provide an extra income boost on a stock that’s not going to move in the short term, such as a low-beta dividend growth stock about to pay out. Or, if you’d prefer, you can use this strategy on companies you already own. Either way, once you’ve picked your stock, simply sell a slightly out-of-the-money call option for every 100 shares of stock you own.
Let’s use Bank of America (NYSE:BAC) as an example. The company pays a good dividend, has an ample option chain, and sports a low beta. (Beta is a measure of a stock’s volatility against a benchmark.) For covered calls, we want a beta of less than one in our stock.
On August 26, just two days after the flash crash, the price of Bank of America’s January 2016 $17 call options shot up 33%. That was the perfect time to sell some calls, because you want to sell an option when its value is high. After the flash crash, BAC’s call options reached their peak out-of-the-money value.
Here’s how it works:
First, selling the call option would’ve netted an “instant” 4% return on shares in option premium. Then, because you’re a shareholder, you’re positioned to capture the December dividend. Finally, you can earn up to 6% in capital appreciation at expiration.
The best part about this strategy? It’s a win-win. At expiration, one of these two scenarios will unfold:
- The options expire in-the-money, meaning the underlying shares are at or above the strike price. This is the best-case scenario. Your shares are called away. You keep the option premium and max out on profit potential.
- The options expire out-of-the-money, meaning shares didn’t exceed the strike price. You can continue to sell covered calls and generate “instant” income.
Bottom line: Volatility in the financial markets is here to stay. And in this kind of market, traders who sell options win big by cashing in on fear itself.