Many income investors use the covered call strategy for monthly income. This is a simple strategy of buy 100 shares of a stock then selling a call against the stock you own. The premium received from selling the call is the income portion of this trade. However, the premium prices can vary from one period to the next. So when is the best time to sell call options?
Since income is the primary objective of this strategy, you should start by looking at what changes the value of call options and premium amounts. The intrinsic portion of a call option is set by the amount of in-the-money value of the option. The amount of variation in option premium is due to the time value of the option. We know time value is higher for longer term calls such as displayed in the options chain for each month of options. So the biggest variation comes from volatility.
When volatility is high, the call premiums are larger than during periods of low volatility. You want to write calls when volatility is high, because you earn more income when volatility is high. To determine market volatility, the VIX is the simplest measure of the cost of options (options premiums). When the price of options is high, investors are scared. If someone has to pay a lot of money for an option above its intrinsic value, then the VIX is high. The general rule is that option premiums are high when the VIX is over 30. For example, on August 8 2011 the VIX was at 48 which was the highest reading in the past year. Back on October 20 2008 the VIX reached 79.13. In comparison, in strong bull markets the VIX can be at 10 or lower. Today, the VIX has dropped to around 24 so the amount of fear in the market has diminished since the August 2011 high volatility area.
The action is that you will receive more premiums (income) when the VIX is over 30 and less premium when the VIX is near the low end of 10 or less. Anywhere in between these points, the option premiums are more fairly priced. This is not to say you should never sell call options when the VIX is low just that you will not make as much income when the VIX is low. For example, when you are writing calls on stocks in your long-term portfolio, you should sell calls after a spike in the VIX.
Again, the VIX is a measure of market volatility. I am not referring to the volatility of individual securities as this will be a different discussion at another time.
One potential trade is to purchase the Powershares S&P 500 Buy-Write Portfolio (NYSE:PBP) when the VIX is high. The PBP normally invests at least 80% of total assets in common stocks of the 500 companies included in the S&P 500 Index and writes (sells) call options thereon. The underlying index measures total returns of a theoretical portfolio including the S&P 500 Index stocks on which S&P 500 Index call options are written (sold) systemically against the portfolio through a buy-write strategy. The chart below shows the VIX price chart and the PBP chart. After the VIX spike, the shares of the PBP will fall creating a lower entry price. Then, the price of the PBP will slowly increase in the months following. There are two items causing this within PBP: (1) the increase in the VIX will decrease the price of the S&P 500 holdings; (2) the higher premiums from call writing will lag behind as the income will not be realized until the new trades are completed. This will give the investor more time to enter the trade before the higher income is realized.
In summary, when the VIX starts to move above 30, watch for shares of PBP to fall. When the price of the PBP stabilizes at a lower price point, then buy shares and look to hold then for 6 months or so into the future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.