2 days ago, when the market was falling, I sold a few covered call contracts and one of them was Tesla. I receive a premium of $1,600 for a covered call contract expiring on 11 March 22 (32 days contract). Strike Price (SP) was $1100.
On 9 Feb 2022, the premium fell and I close the contract by buying it back at $1062, thus making a profit of $538 in 2 days. The reason for this happening was because of the change in Implied Volatility (IV).
Implied Volatility (IV) refers to the probability of the fluctuation in the market price of a stock, in short, it is a prediction of how volatile the stock can be at a certain point. The higher the IV, the more volatile in price movement the stock is expected to be.
IV matters because the higher the IV, the higher the premium for a given option contract. A high IV means the seller of the option contract (whether PUT or CALL) will have a higher risk of the contract not going his way and thus he will be compensated with a higher premium because of the higher risk involved.
On Monday, when share prices were dropping, Tesla’s IV was high at 55%, thus the premium was higher. As an options contract seller, I earned a higher premium. 2 days later on 9 Feb 22, the share price of Tesla rose and IV dropped to just over 40%, so the premium for the contract dropped even though the share price rose higher than the share price when I sold the contract. This is due to an inverse relationship of share price and IV. When the share price drops, IV rises and vice-versa. Thus, the lower IV and lower premium favor the buyer of the option contract.
To take advantage of the situation, I sold when IV was high (higher premium) and bought back to close the contract when IV was low (lower premium), and earned a profit and closed the contract and had no contractual obligation to fulfill.
IV is an important metric in options trading and buying when IV is high, e.g. near earnings report, may lead you to suffer from IV crush when the earnings report is released, i.e premium drops significantly even when the share price has increased after the earnings report.
Read more about IV in this article:
What Is Implied Volatility (IV) And Why It Matters In Options Trading?
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