So how do you know when its the right time to sell a covered call? For many of us that invest for the long term, we like to sell covered calls as a nice way to continue to offset our cost basis, but how do you know when is the right time.
Recently a friend asked me what I thought about the price of oil lately. A fair question seeing as how the price at gas stations seems to fall almost every day. He tells me that he bought
Now USO, if you're not familiar with the ETF, is the United States Oil Fund, a portfolio that maintains a rolling long position in crude oil futures. Over the past couple of years, USO's share price has slumped from $40 to $10.
So, after a brief conversation about oil my friend let's me know that he has been holding this whole time and wishes to continue to do so. He tells me that he has been selling covered calls along the way but cant seem to get a grasp of when is a good time to sell new covered calls. He says he just sells them as the others expire but has no idea weather he is getting a fair price or not. This is a common issue for investors who are new to covered calls and today I will offer you the very same suggestions I offered him.
Writing covered calls, I told him, is a smart way to lower his USO basis in a flat or modestly bearish market, but in a steep downturn that strategy won't provide much protection. The maximum benefit, of course, is derived when one sells calls that are "rich" (contracts whose premiums are overpriced).
How do you know when USO options are expensive? Well, with the S&P 500 we can look at the VIX and get a feel for the level of fear in the S&P 500. When fear is high then you will find that option pricing is "rich". With oil we can zoom in a little further and see what the fear level is on oil itself. We can do this by watching the OVX, the CBOE Oil Volatility Index. OVX uses the same methodology to gauge fear in the oil market as VIX does for stocks. And, not surprisingly, OVX is inversely related to USO's price: OVX spikes upward as oil's (and USO's) price tumbles.
Over the past five years, OVX has averaged a reading of 34 (34 percent annualized volatility). Right now, OVX is over $45. Does that mean USO options are rich? Maybe, but you would still want to look closer at the volatility of USO over time.
The bottom line is that you can use these indicators to get a feel for the pricing of your options. If the overall volatility is low then you may be best to wait to sell covered calls, or if you must then you will find you need to come closer to the money to make it worth your while.
