Most of the in the money October calls were exercised or sold, as we expected.  But as discussed yesterday, they had no time value and a very low implied volatility, 14, right where the historical volatility is.

I sold the Nov 46 calls and bought the stock.  Actually, I jumped the gun and did the buy / write day before yesterday.  Today when I went to unwind the position, I came out flat.

Generally, if you are taking no risk, you can only expect to earn the risk free rate, which is very low. That is what is going on here. I have to figure out which risks I can take on with this strategy to make a decent return.

Back to the drawing board.

Why Bother?

Why try to figure out a way to capture dividends? You make pennies. But they are high quality pennies. Any time you can lock in a return, even a small one, that is very high quality money. We will do the return calculation at the end to see if it is worth it.

Today’s Target

Phillip Morris (PM) goes ex-dividend tomorrow, 24th September, paying $0.58 in a few weeks. So today is the come date. In the money call owners who want the stock will call it away today. And call owners who fear a drop in the value of the call will sell their call today.

So I thought that I would buy stock and sell calls so that the stock would be called away. I would get the time premium in the call. So I need a call that is in the money and has a small enough time premium to make it worthwhile for the call owner to call it away.

Which Call To Sell?

This is the Oct in the money call option chain, 7:30 this morning, before the market opens. (Click on the picture to enlarge.)

The 48, 47, and 46 calls are trading with the dividend payment already accounted for. Notice that their implied volatility is lower than the historical volatility of the stock. The deeper in the money calls’ bid and ask bracket PM’s price, 48.93. they have no time value left. So there is nothing to do here.

Let’s look at the Nov option chain for the in the money calls.  (Click on the picture to enlarge.)

We can make a table to make it easier to compare.

To me, it looks like the Nov calls with strikes 46 and lower will be called away. The 47s and 48s have too much time premium and so are too expensive to be called.

As a further check that this is the baseline implied volatility level, we look at Dec too.  (Click on the picture to enlarge.)

Expected Return

So buying a share of PM and selling a 46 Nov call would cost $48.93 – $3.2 = $45.78 and if it is called away, we make $0.27 time premium. So the return is approximately one half of one percent. The risk is that the stock isn’t called away.

I will report back later.

Safe Dividend Capture

Call holders don’t get the dividend, so my idea was to buy the ETF and sell in the money calls. If I sold September calls, they would have, most likely, been called away since there was very little time value left in them.

So I sold October 103 calls for close to $5. There was $0.70 of time value left in them making them too expensive to call away for a $0.52 dividend.

What I thought would happen is that the calls would drop in value by $0.52 * delta or about 40 cents, reflecting the drop in price of SPY. That would be my return from the trade, minus transaction costs and slippage.

This morning, as expected, SPY was trading lower, but the calls were unchanged!

Solution To The Mystery

I looked at the implied volatility of the calls at yesterday’s SPY price, and it was 14, the same as the historical volatility of SPY. Today, at the new SPY value, the implied volatility of the calls is 21, in line with all the other options.

So the option was already discounting the dividend yesterday.

Even if that argument doesn’t convince, he does mention an interesting trade, which is to buy September 30 or 32.50 VIX (Chicago Board Options Exchange volatility index) puts and hedge with at the money SPY (ETF that tracks the S&P 500, whose implied volatility is measured by VIX) puts. What happens is, if the VIX drops as the market rises, the VIX puts make money, but the SPY puts lose value. If the market drops, the SPY puts increase in value, but the VIX puts lose value.

Now the question is, how much of each to buy?

Vega

What we have to look at is, for a move of, say, ten points down in the S&P 500 (which is equal to one point in the SPY) which would make our SPY puts more valuable, how much would VIX drop, which would make the VIX puts less valuable?

How much would the value of the SPY puts increase for a 1 point drop in SPY? Since their delta is near -0.5, they would increase in value by half a dollar.

That is one piece we need.

We need to figure out how much the VIX puts drop in value when SPY drops. To do that we use the SPY vega. Vega of SPY is 0.12 so the change in the implied volatility of SPY would be given by the change in the SPY option value divided by the option’s vega, or 0.5 / 0.12 or 4% for a 1 point drop in SPY. But this is 4% of the implied volatility. Since the implied volatility is 27, this gives a change of the implied volatility of 4% of 27 which is about 1. So the implied volatility would go from 27 to 28.

This change is the underlying that moves the VIX puts. So since the VIX 30 puts have a delta of -0.7, that would change the value of the VIX puts by (-0.7) * (1) = -0.7

So it is these two changes in value that we want to hedge. It looks like we would need about 7 SPY puts for every 5 VIX puts (7 SPY * 0.5 + 5 VIX * (-0.7) = 0).

Where Does The Profit Come From?

One way to figure that out is to look at the vega of the SPY puts and compare it to the delta of the VIX puts. That way, we are looking at the change in the value of the SPY puts when their implied volatility changes (that is what vega measures), and comparing that to the change in the VIX puts when its underlying (the implied volatility of the SPX index) changes.

The vega is the change in the value of the option for a small change in the implied volatility. For the 99 or the 98 SPY put, vega is $0.12 and the delta of the September 30 VIX put is -$0.71. For the September 32.50 VIX put the delta is -$0.89. So we would have to buy six times as many SPY puts as VIX puts. That would make us immune to movements in the implied volatility.

If we bought 7 SPY for every 5 VIX, we would profit from the change in implied volatility calculated above. The VIX puts are six times as sensitive to changes in implied volatility of the SPX as the SPY puts are. If the S&P implied volatility drops, the vega measures the change for the SPY while it is delta that changes the value of the VIX puts.

The August 95 straddle was selling for around $10, so I built the dual calendar spread around 85 and 105. Also, the August implied volatility was 45% and the September, 41% for the at the money calls. There were around 40,000 calls open around the money and 26,000 puts around the money which isn’t overwhelming. So I kept it symmetric. Here is what it looked like around the middle of the day when I calculated it. The profit curve for tomorrow is the colored line below the x axis. (Click on the picture to enlarge):

If the August volatility collapses to the September value tomorrow, the curve will look like this(Click on the picture to enlarge):

That is a return of $0.72 on an investment of $2.57 or 28%. The implied volatility of the August call has dropped to 27% and the August put implied volatility has dropped to 32.5%

The underlying for the VIX is the futures contracts so, for example, calendars do not work the same way. The out month moves independently of the near month.

The 30 day historical volatility of the VIX is 84% while the at the money options, at 25, have an implied volatility of 64%. Right now VIX is trading just below 25, so it would be a coin flip if the puts end up in the money or not.

Google Dual Calendar Spread

The July options’ implied volatility is much higher than August. After earnings the implied volatility of the near month collapses. What effect does that have on the profit graph?

Here is the profit graph of the dual calendar spread with the volatility skew.
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This is what happens if the volatility of the near month options drops to the implied volatility of the far month options.

The intermediate profit rises to the final form when the near month volatility drops. So you get an added lift from the implied volatility collapes.