Calling all traders
07/19/18

Trading and investing are different animals, and traders who approach the markets like long-term investors are just as likely to get their lunch eaten as investors who act like short-term traders.

But occasionally, these animals can profitably share the same jungle.

Case in point: What to do with an uptrending stock that’s trading near its recent highs. An investor who intends to hold the stock a long time may attempt to earn some extra income by selling out-of-the-money (OTM) call options (i.e., strike price above the current stock price), a trade referred to as a “covered call” because the short call position is protected by the underlying stock position: In a worst-case scenario, if the stock rallies above the strike price, the investor may have to sell the stock at the strike price (presumably for a profit), and will also keep the premium collected from selling the call.

Ideally, though, long-term investors want to sell call options that won’t be exercised. That means selecting a strike price far enough above the current stock price that shares are unlikely to exceed that level before the options expire.

But savvy options players know there’s more to it than that, and that’s where the overlap between investing and trading comes in. Whenever you’re selling options, you want to maximize your edge, and that that means finding, if possible, options that are potentially overpriced.

Cree (CREE), 8/9/17 – 7/18/18. Cree (CREE) daily price chart. Uptrending stock

Source: OptionsHouse


One way to help do that is to identify options with recently increased implied volatility (IV). High IV—which is the market estimate of future volatility contained in an option’s price—can, all else being equal, translate into higher options values.

The chart above shows LED and semiconductor manufacturer Cree (CREE), which yesterday was trading around $4 below its record high from about a month ago—the apex of a 147% rally from the stock’s August 2017 low (not a bad 11-month return). A long-time holder of the stock who expected the stock to continue pushing higher could choose to sell some OTM calls—say, somewhere above the June high—to generate some additional income.

Meanwhile, a short-term trader who first expected the stock to move more or less sideways for a few weeks, or possibly test its early-July swing low, may also see a reason to short (uncovered) call options. Two outlooks on the stock, same trade—and the same need for the investing and trading animals to stalk relatively overpriced options.

Yesterday, a LiveAction scan for symbols that have made large one-week increases in 30-day IV showed CREE near the top of the list—up nearly 42% (below). So, all else being equal, CREE options premiums should have been relatively high to where they were the previous week.

LiveAction scan: Largest one-week IV gains, 7/18/18. 42% IV increase

Source: OptionsHouse


Also, CREE shares were trading higher on the day, which (again, barring other factors) should pump up call options premiums. The CREE August call options prices shown below were, in fact, almost all trading up on the day.
Cree (CREE) August call options, 7/18/18. Higher call premiums.

Source: OptionsHouse


Does that mean such a trade is a guaranteed success? No, but traders looking to sell calls—covered or uncovered—can help their cause by doing so when IV has increased and the stock is trading up.

Market Mover Update: Airlines have heated up in recent days, with the latest boost coming from an improved outlook from United Continental (UAL). Delta Airlines (DAL), which rallied after beating its quarterly estimates last week, shot up more than 3% yesterday.

 

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