Implied Volatility of ETFs and Our Covered Call Writing and Put-Selling Decisions

04/29/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman, of TheBlueCollarInvestor.com, compares and contrasts option trading with ETFs versus with individual stocks, including the benefits as well as the drawbacks of each method, plus how to evaluate risk level by observing the implied volatility of the associated options.

Covered call writers or cash-secured put sellers who use ETFs (as opposed to individual stocks) tend to be novice put writers, more conservative investors, or have limited funds or time. If you fall into any of these categories, knowing your risk level is critical to your investment decisions and specifically, to which underlying securities you select. One way to evaluate this risk level is to view the current implied volatility (IV) of the associated options. IV is the forecast of the underlying security’s volatility as implied by the option’s price. The implied volatility is calculated by taking the market price of the option, entering it into an option-pricing model, and back solving for the value of the volatility. The higher the implied volatility, the greater the option premium will be but also the more risk incurred regarding potential downward movement of share price. The figure below is an example of the implied volatility stats we provide to our members in our premium reports and their comparison to the overall market (S&P 500):

chart
Implied Volatility stats from the BCI premium member ETF report
Click to Enlarge

Another way to view implied volatility is the anticipated market view of the percentage change in the price of the security on an annualized basis in either direction. In the chart above, we see that EPI has an IV of 33.11 or about 33%. If the price of EPI was $21, then the market is anticipating a price range of $14 to $28 over the next one year ($7 in either direction or 33% of $21). The higher the IV, the more risk we are incurring for a potential price decline. As a comparison, at the top of the chart, we see the IV of the overall market (S&P 500) at the time was 13.31.

Summary

ETFs and stocks can be used as the underlying securities for covered call writers and cash-secured put sellers. The major drawback to selling options backed by ETFs is that the return—or premium—generated from the sale of ETF-backed options tends to be lower than the returns produced from the sale of stock-based put options (given that ETFs typically have lower implied volatility than individual stocks). In the context of writing options, ETFs tend to be more appropriate for the conservative investor, the investor with limited time or capital, or the novice investor. Personally, I prefer to write options that are associated with stock in my portfolio, however ETF-backed options are the preference when I invest for my mother’s (more conservative) portfolio. It is up to you, the reader, to determine which is best for your portfolio based on finances and risk tolerance.

By Alan Ellman of TheBlueCollarInvestor.com

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