I enjoyed your article on using ratio backspreads for volatile stocks. What strategies would you use to harvest premium on a 99th percentile implied volatility stock like OSIP or GNTA? The goal is to grab premium without being hit by a volatility crush or huge price swings.Thanks for any input.-- J.J.
This reader's question brings together several concepts that I've recently written about, the first being the use of high implied volatility as a criteria for establishing
covered call positions. In that article, I identified
as a covered call candidate because of its extremely high implied volatility. At that time, OSIP was trading around $38 and the implied volatility was around 110 for May options.
About seven days later, the company received some good news and the shares rocketed to the $90 area. While many readers thanked me for putting this name on their radar screen and realizing a 15% profit in less than seven trading days, I was somewhat embarrassed that we'd left the other 100%, or $45 portion, of potential profit unrealized.
I use this example to segue into some questions I received about this week's
article on using ratio spreads to harvest premium in what seems to be unduly "expensive" options in
New York Community Bank
. As I wrote, having a comfort level about the potential range or limits on an ensuing price move is crucial to selling premium or having a short gamma position.
One way to make sure you won't be exposed to undue or unlimited risk is simply to make sure that the number of options (either puts or calls) you are long is equal to or greater than the number of option contracts you are short.
On the OSIP example, although the suggested covered call left money on the table and capped the potential gain at 15%, the one-to-one position did prevent exposure to an unlimited loss. So one way to "harvest premium" in high implied volatility situations would be to establish a credit spread, but to buy enough out-of-the-money calls (or puts) to make sure you're protected against an unanticipated event or reaction, like a 100% price move.
A suggestion from a reader (thanks, Mike G.!) illustrates how a change in implied volatility affects a ratio spread's value. The initial assumption is XYZ Corp. trading at $50 with the June options having an 80% implied volatility, and the initial position of buying one June $50 call and selling two June $60 calls was established two weeks ago (45 days until expiration) for a net cost or debit of 65 cents per 1-by-2 spread.
The table shows the value of the position given various implied volatilities and prices in XYZ Corp. shares with 25 days remaining until expiration.
I hope this table helps illustrate the dynamic nature of options valuation and the limitations of just viewing value from the expiration date vantage point.