Best Time Ever to Trade Options Leads to...Lower Volume?

I don’t dispute the facts of this article. Here’s the key takeaway:

The number of outstanding calls and puts sank as much as 46 percent in January to 153 million, the lowest total in three years, according to data compiled by Options Clearing Corp. Trading slowed from a year earlier for the third consecutive month, the longest streak since May 2002, data from the Chicago- based derivatives clearinghouse show.

Part of the reason given for the decline is that volatility has gotten too high.

What is surprising is that just a couple of months ago, the high volatility prompted this:

A popular investment strategy involving the purchase of stocks and the sale of options has generated the highest premium in two decades, according to the Chicago Board Options Exchange.

Known as a “buy-write,” the strategy would have produced a gross monthly premium of 8.1% in November, marking the highest percentage on record since 1988. It generated the second-highest premium, 7.1%, in October.

The CBOE tracks a hypothetical version of this strategy via its BXM Index, measuring the performance of a transaction involving the sale of calls against the Standard & Poor’s 500-stock index. Calls convey the right to buy a stock at a fixed price, so sellers are allowing third parties to buy the stock from them at that price.

On Nov. 21, when the premium was most recently calculated, the BXM assumed the sale of December 750 calls in the S&P 500, against a position in that index.

The goal of the buy-write is to sell calls that eventually expire worthless. As a result, the strategy works well in most types of markets, except robustly bull markets.

The transaction can generate juicy premiums because the price of options are determined in part by volatility in the stock market, and volatility has climbed to an all-time high.

So you have the most popular options strategy out there — the covered call / buy-write — yielding the highest potential profit EVER, and what happens? Options trading COLLAPSES.

Now I realize that there are some additional nuances in the Bloomberg article that have caused options traders to pull back, such as the implosion of hedge funds and the huge decline in wealth. My favorite was Interactive Brokers Group saying that they stopped making markets in options that expire more than six months into the future.

But the fact is that the premium that made covered calls so attractive in November should cause option sellers to have a field day. Now is the precise time that individuals have an advantage. Folks that want to trade once a day and walk away (and not sit in front of a screen all day) should be looking at covered calls or cash-secured put selling — at least if you have the kinds of tools that allow you to do the proper analysis.

Comments

[EMS:]

There is less liquidity, and people/ firms have lost so much of their capital, that it stands to reason fewer options are being sold.

Feb 06 06:25 AM

[ANTS:]

Fact is that with downside risk so high, the chance of losing capital far exceeds the income potential of selling calls. In addition, stock price moves are quite volatile in either direction, masking any trend while instilling a high degree of non diversifiable fear. The current market is not a good one for this strategy at all.

I haven't investigated this myself, but it is likely that call and put backspreads which capitalise on fast up or down moves with limited downside would yield the best results.

Feb 06 06:35 AM

[Don Fishback:]

Seeking Alpha editors removed the last paragraph of my original blog post that discussed DEEP in the money covered calls. That's a key omission.

For instance, ANTS correctly brings up the issue of downside risk causing the loss of capital. But here's a for instance why I like those deep ITM covered calls. I did a trades on MBT, AXP and BK. In each instance, the stocks FELL more than 20% after I implemented the trades. But here's the key, in each instance, the breakeven prices of the covered calls were more than 30% below the then-current stock prices. So in each case, I made profits. And those profits were not small. In each case the profit potential exceeded 20% return. Not annualized return. Straight up one month returns.

The point is, I agree that the risk of large downside is high. But with the deep ITM covered calls (which is what the last paragraph discussed), you can withstand that kind of catastrophic fall.

I wish that last paragraph had not been deleted!

Feb 06 11:19 AM

[ANTS:]

Odds, thank you. I didn't mean to be critical, its just that I adopt this strategy, and I have been losing quite successfully in the past 6 months, and with hindsite have been trying to adopt better strategies. Certainly this is one.

Feb 06 04:00 PM