Covered Call Writing Opportunities

The MX Implied Volatility Index (symbol MVX) has virtually doubled in value overnight. At the end of day Thursday, the MVX closed at 24.05, a full 10 points higher than readings earlier in the week. It followed a similar reading on the CBOE Volatility Index (symbol VIX, recent close 26.48) also up more than 10 points in the past week.

The MVX tracks the volatility implied by options on the iShares S&P/TSX 60 Fund (symbol XIU, closing price on Thursday $77.90). Higher volatility readings mean higher option premiums.

How much higher? Well, suppose you were looking at the September 78 calls on the XIU. The closing bid price on Thursday was $2.51, which equates to a 24% implied volatility. Last week, all other things being equal, that option would have been trading at a 14% implied volatility, which would have valued it at $1.55.

What we know then, is that volatility is very important when choosing an option strategy. What these implied volatility readings are telling us is that traders are worried. Waiting for the next sub-prime shoe to drop.

What serious investors need to do, is separate the wheat from the chaff. In this case, make a reasonable assessment of just how bad the credit crunch actually is. The analysis of which is far to extensive for this space. Although, when the dust settles, it usually turns out that investor fear was far greater than the actual risk.

On the positive side, the probability that the Bank of Canada will raise interest rates again in September, has dropped significantly. Something I thought was likely long before this debacle.

Another interesting aspect is the performance of the Bear Stearns Companies (symbol BSC, listed NYSE), which closed Thursday at US$114.05. It slipped another US 82 cents in after hours trading, but at that price point, it was still above the lows set on Monday (US $100.55).

Monday’s sell-off followed comments from Bear Stearns Chief Financial Officer about the seriousness of this credit crunch. Equating investors rush to the exits as similar to the panic of October 1987 and September 2001.

Since Bear Stearns was considered by many as the major investment banker in the US sub-prime lending game – including the management of hedge funds in that space – it is not surprising to see that company take the biggest hit. That the stock is still well above that level, suggests that traders may believe we are close to a bottom. Time will tell.

What we do know, is that this is one of the best covered call writing opportunities the Canadian market has seen for the last three years. That is if you fall into the camp that believes the world is not coming to an end.

There are great opportunities to write covered calls on Canadian banks with implied volatility numbers above 22% across the board. Even better examples exist among the oils like Canadian Natural Resources (implied volatility 38%), Suncor (IV 34%), and the golds like Goldcorp (IV 40%) and Barrick Gold (IV 38%).