I got a great question on my earlier post on why it works best to write covered calls on medium-volatility stocks. What is "medium" volatility, anyway? I thought it was worth repeating my response here, in case others had the same question. (Thanks for bringing this up, Jey!) Here's a rough guide for the volatility "sweet spots" I look for on one-month covered calls that are currently ATM (at-the-money):
Price of stock Implied Vol.
100 -- 20%
50 -- 25%
20 -- 30%
If you go even further out in time, it's fine to consider stocks with lower implied volatility. The added time value will increase the premium to an "acceptable" rate, but this obviously means you might be in the position longer than originally planned. Just weigh the trade-offs before proceeding.
If you do opt for larger implied volatility, the downside risk of owning stock is big -- I can't emphasize this enough. Investors get enticed by the high premiums they can earn on options with higher IVs, but often they don't realize that high implied means the stock is just as likely to go down as it is to go up. On the upside you are okay, but if it makes a quick move to the downside, as a long stock holder you are definitely not - and if the move happens overnight, you might find yourself incurring a much larger loss than anticipated. Too often I've heard stories of this happening to new investors, asking themselves "how did that happen?" The answer is nearly always the same: they went for HUGE IMPLIED VOLATILITY!
Of course, it's important to keep in mind that any stock - no matter what the implied volatility - can get cut in half overnight. But you can play it safer by heeding the obvious dangers that high implied volatility suggest.
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
