Market Volatility is Your Friend – Here’s Why
Last Week's Income Report: February 7th, 2021
Investors typically view volatility as their enemy, which means 2022 has been a losing battle for them. But options sellers know that volatility is their friend.
Volatility is one of the components of an option’s price. Higher volatility translates into higher option premiums, which benefits option sellers.
To illustrate this point, let’s run through one of the trades we put on in Options Income Blueprint last week. It’s a great example of how to balance risk and reward in a market like this while capitalizing on elevated volatility.
The trade was on semiconductor manufacturer Micron Technology (MU). Before I get to the trade details, let’s look at why I chose this stock, because it is part of our risk mitigation approach.
Selecting a Stock to Trade for Income
When choosing a stock to trade for income, I use a top-down approach that puts fundamental first. It flows like this:
- Trend
- Company
- Stock
- Chart
- Option chains
- Premiums
By focusing on fundamentals rather than simply chasing premium, I limit risk by trading sound companies. Here’s how that looks for MU…
Trend: High demand for semiconductor chips due to the explosion in mobile devices and data center servers.
Company: Micron is a leader in solid-state drives (SSD), and also produces DRAM and NAND flash memory chips.
Stock: MU is wildly undervalued, selling at less than 9 times forward earnings compared with a forward P/E of 20-plus for the S&P 500.
Chart: MU sold off sharply with the chip sector and tech stocks in general. At the time we entered the trade, shares were down 17% from their high with support around $77.50.
Option chains: MU’s option chains are liquid and easy to trade week to week.
Premiums: An trader can easily generate 1% a week selling out-of-the-money puts at the beginning of the week.
Trading MU in a Volatile Market
Due to market conditions, I wanted to sell a put that was considerably out of the money to reduce our risk. Now, the further out of the money you go, the lower the premium you receive. But, when volatility is high, you can often generate a good rate of return by selling a further-out-of-the-money put.
With MU trading at $81.79 on Feb. 1, I recommended members sell a MU Feb Monthly (2/18) 75 Put. Even though that put was more than 8% out of the money, heightened volatility allowed us to capture $1.02 in premium, or $102 per contract. The 75 strike was also below the stock’s 20-day low, providing me with even more confidence in the trade.
As you can see in the Put Calculator below, our potential return for this trade was in line with our goal of generating 0.5% a week and 26% annualized per trade.
If this option expires worthless, we stand to make a 1.4% return in 18 days, or 28% annualized. While that is slightly above our stated goals for the service, it’s actually a bit on the conservative side for us. But, as you probably guessed, that was by design.
First, given volatility in the sector and the fact that the market only had two days of a rebound behind it, I wanted to be cautious.
Second, I was assuming the stock would continue to trade above $80 and would likely pull away from that level. In that case, we would have the opportunity to roll the put – buying back our current option and selling another one with a higher strike. Not only would this allow us to generate more income, but it would also increase our potential rate of return.
For instance, let’s say that we were able to generate an additional $0.64 by rolling up to the 80 strike, bringing our cash in hand to $1.66.
Now, if the option expires worthless on Feb. 18, our rate of return will be 2.1%, or 42% annualized. It’s very possible I will recommend a roll like this one in the coming days. We may also have an opportunity to book profits early if MU moves in our favor.
As you attempt to trade this volatile market, I suggest you take a similar approach, beginning with fundamentals and working your way down to option premiums. And remember, volatility is your friend.
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