“You can never be too rich or too thin.” This famous quote is attributed to Wallis Simpson, the twice-divorced American Duchess of Windsor, but several others have been praised for this or similar words. A doctor may suggest that the person may indeed be “too thin” or, in an investment context, that securities may be a little “too rich.” When examining the performance of various sectors since the beginning of this year, a few sectors stand out in particular. The energy sector is up ~19% so far this year. Local banks and materials rose by up to 13.6%. Daily necessities and industrial products also experienced double-digit growth. In general, it’s healthy for stock market performance to extend from tech stocks to these other sectors, and from mega-cap stocks to smaller companies, as evidenced by the Russell 2000 index outperforming the S&P 500 index so far this year. However, stock prices do not rise in a straight line. It could be oversold in the short term or extended a bit. This may be the case with current materials. Since October 7, 1999, the average 30-day price change for State Street Materials Select Sector SPDR ETF (XLB) has been approximately 55 basis points (0.55%). Below is a histogram of those results. The column containing the average return is highlighted in blue. However, things change dramatically when XLB expands beyond its 200-day moving average. At the moment, XLB is in the top 10 compared to its 200-day moving average. The top decile histogram by this indicator again has a significantly different average return, with -0.22% highlighted in blue. Selling a covered call on XLB makes sense when two conditions are met. The first is when prices are skyrocketing, as we’re seeing now, and the second is when option premiums are unusually high. Currently, 1-2 month implied volatility is approximately 1.7 standard deviations above the two-year average. Even if an ETF trades significantly above its long-term moving average, there is no guarantee of a decline. The histogram above shows many situations where the rise continues. However, the potential for market volatility has certainly increased, and average returns have fallen significantly over the past 28 years. If XLB pauses after the strong rally it has seen recently, the option’s external value will fall, preserving the premium and effectively turning the stall into income. Lengthening is also important psychologically and mechanically. When prices rise, marginal buyers often become more sensitive to headlines. For materials in particular, it often depends on commodity price expectations, with gold and silver, two of the most prominent, suffering significant declines over the past week. Implied volatility is the price of convexity. If the IV is 1.7 standard deviations above the two-year average, the option is expensive relative to its recent history. This is important. Because a covered call is, in layman’s terms, an overlay of short volatility. In other words, you collect a premium upfront in exchange for giving someone else the right to buy your stock at the strike price of the call. 30-60 DTE calls tend to have a good balance of premium, liquidity, and responsiveness to changes in volatility (aka “vega”). Deals At the time of writing, late-March expirations are preferred, such as the usual March 20th expiry or the end-of-March March 27th expiry. Typically, 20 to 30 delta call options provide a good balance of return and potential upside versus short strikes. The less “headroom” you think you need, the higher the delta for your short calls. With XLB growing relative to long-term trends and short-term IV being unusually high, the market offers a relatively attractive trade. That means selling expensive insurance in ETFs that can be a bit indigestible in the short term. In such an environment, covered calls can improve risk-adjusted outcomes by capturing premium and forcing discipline on exits without having to predict the exact timing of a pullback. Disclosure: None. All opinions expressed by CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, its parent or affiliates, and may have been previously disseminated on television, radio, the Internet, or another medium. The above is subject to our Terms of Use and Privacy Policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any securities or other financial assets. The Content is general in nature and does not reflect any individual’s unique personal circumstances. The above may not be appropriate for your particular situation. Before making any financial decisions, you should strongly consider seeking the advice of your own financial or investment advisor. Click here for full disclaimer.
