BY: NICOLAS PIQUARD, CFA®, VICE-PRESIDENT, PORTFOLIO MANAGER AND OPTIONS STRATEGIST, HORIZONS ETFS
April 6, 2018
A new volatility regime is upon us, but the transition has been more violent than anyone could have expected. While the VIX (CBOE Volatility Index) had trouble staying above 13 last year (and in reality spent much of the year below 11), this year has been markedly different thus far. For covered calls, this represents a big shift in outlook from both a premium intake and potential yield perspective.
When writing out-of-the-money calls, the premium received from a call sale can rise exponentially with an increase in overall option volatility. Take, for example, a two-month 4% out-of-the-money call on Apple Inc. At a10% implied volatility, assuming no upcoming dividends, this call would be expected to trade at approximately $0.68. However, at a 15% implied volatility, it would be expected to trade at $1.73. So, with a 50% increase in implied volatility, we are now receiving approximately 154% more call premium than before.
This illustrates the difference that a broader and more prolonged increase in general worry levels can make in a covered call portfolio. An even more pronounced shift in the average VIX from 2017’s average of 11% to this year’s average (thus far – as at March 4, 2018) of 17.50%, is resulting in far better premiums than we’ve seen in years, and this comes at a time when equities have been having greater difficulty pushing to new highs. In fact, from a technical standpoint, there is reason to believe that stocks will continue to struggle here. I believe there are four key reasons for this:
1) Technology is in the headlines in a negative way. Yes, Amazon will probably still take over the world, but Trump is highlighting some issues that will weigh on what has been very crowded trade positioning in the top tech names. Volatility has been increasing particularly in large-cap names and technology companies now account for about 25% of the S&P 500 Index. If the technology sector remains weak, the market as a whole could potentially struggle as well.
2) A lot of trades over the past few years have been similar in nature, i.e. long risk assets = short volatility. The market’s behaviour in early February may have been a good example of how positive feedback loops from unravelling trades can cause instability and volatility. Selling begat selling as momentum picked up to the downside. Years of low interest rates left investors with few options aside from equities. As these crowded trades unwind, we face the continued prospect that they may not happen in an orderly fashion.
3) Central banks continue to withdraw stimulus. Think of low interest rates to markets as catnip is to a feline. Inflation and higher interest rates will continue to spook investors.
4) U.S./China trade uncertainty is continuing to cause turbulence.
Expect the unexpected and more potential spikes in fear gauges like the VIX. I believe this in turn will keep equities volatile. Better option premiums and yields, combined with struggling equities and rising bond yields means now could potentially be the time for covered calls.
Average VIX in 2018 (as at March 4, 2018): Approximately 17.50, versus 11.09 in 2017
Source: Bloomberg, from December 11, 2016 to March 4, 2018.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.