Stocks expecting a massive change in price will see options premiums inflate in conjunction with implied volatility.
- Some prefer to buy these stocks and hold them with the associated high risk stakes.
- Some will buy shares but heavily hedge with deep in-the-money covered calls.
- Others will sell cash-secured put options that are out-of-the money to gain the same effect. (Please note this is NOT naked options writing)
Covered Calls or Cash Secured Put Selling?
This issue has come up before as to which is a better choice. Each side has its strengths and weaknesses.
Deep in-the-money covered call writing is beneficial if dividends are available on the shares. You lower your net cost per share through covered calls thus effectively raising yields. But it is unlikely that an extremely high implied volatility stock has big dividends such as a blue chip company. Also, option premiums are reduced to factor in future dividends. Covered call writing on high implied volatility stocks helps you achieve your goal of appreciating share prices since you are buying stock which should help support prices. (You may want to read more on Applying Covered Call Writing to Blue Chip Stocks).
Selling cash-secured puts has the perk of fewer transaction fees than covered call writing since you are only selling one product instead of buying shares and selling calls.
One of the biggest determining factors between which method to choose is likely going to be open interest and volume. You may want to buy shares and sell deep in-the-money calls, but if there is only a smattering of open interest with reduced liquidity, you may get a poor price when you have to sell at the bid. The comparable put options may have extremely high open interest giving you the competitive entry point you are looking for with a tight bid/ask spread. It could go the other way too.
Also, keep a close eye on options volume since a study has linked a surge in contracts to future stock prices. You can read about that here.
High Implied Volatility Puts
Keep in mind, we are picking some of the most volatile and risky stocks in the market. Our hope is that share prices will not fall down to our written put options strike price, thus allowing us to keep all of the profit. If it does fall below the strike, we will be buying the stock in the future which could lead to total profit loss.
OTCPK:CCME – September 2011 Puts with strike price of $10. Current share price around $12. Over 50% return is share prices are above $10 by fall. Prices recently dumped from around $24, and some support around $8. Break-even point should be somewhere between $8 - $8.50 depending on when you trade. Fraud allegations are rocking this Chinese advertising agency.
ALY – Allis Chalmers April or May 2011 Puts with a $7.50 strike can return over 60% profits if prices don’t fall too far from where it is trading just pennies above that now. Break-even point is somewhere around $4.50. This stock is in the oil and gas equipment and services industry.
DCTH – January 2012 Puts with $10 strike ($10.50 current price) may return around 64% profits if prices don’t go much lower. Break-even point is around $6.50. This healthcare industry is working on cancer delivery treatments so FDA approvals are of paramount importance.
Again, keep in mind that this is only suitable for people wanting to add a splash of high risk excitement into their diet. Other pharma stocks such as ARNA have shown the dangers of companies seeking a binary decision such as an FDA approval. If you like to walk on the wild side, selling cash secured puts on these high implied volatility stocks could be a blood-pressure raising experience to possibly earn a few extra dollars. These could also be good potential short plays, if you are into momentum stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.