Covered Calls: The Sweet Spot, Part 2

by: Reel Ken

"Boxing is real easy. Life is much harder." Floyd Mayweather, Jr.

My recent article put forth the concept of selling naked calls on an index, such as the S&P 500 (SPX) instead of covered calls on individual components in a selected portfolio. The comments and e-mails suggested that many readers wanted additional information. After all, covered call strategies are growing in popularity and "devotees" are slow to change.

So, let's break it down into more detail...

The first issue that needs to be addressed in any covered call strategy is setting the strike prices. We all know that in a perfect world, the investor would set the strike at the level that precisely matches where the underlying finishes at expiry. This results in the maximum premium collected without compromise on return. Set the strike too high, you give away premium, too low, you give away return. In the real world, it is impossible to routinely get it right. Instead most investors must rely on some sort of personal calculus to balance premium vs. potential.

Now, the SPX has been extensively researched and has volumes of data associated with it. The CBOE has even developed several indices that track covered calls on SPX. In a past article I explored these indices in detail and concluded that selling calls on SPX, precisely 2% OTM was the "sweet spot".

I must mention that SPX does have a high exposure threshold. Each option controls over $140,000 in value. Many investors would need to use either the mini-SPX or the iShares SPDR S&P500 ETF (NYSEARCA:SPY). I suspect there is some minor tracking errors when compared to SPX, but that could go either way.

The index for this is BXY. The CBOE link for more detailed information on BXY is

So, much of the guesswork surrounding setting the strike has been resolved using the SPX and 2% OTM calls. The data, collected over 25 years of up and down markets, supports this level. The individual investor could deviate from this as they wish, but they, at the very least, have a very good indication and starting point.

What about setting strikes for a portfolio account?

Well, we all know that each individual's portfolio is unique. You are not going to find any research, let alone exhaustive research to indicate your optimum strike level. Is it 2% OTM ? 3% OTM? I don't know. Furthermore, it will vary from individual to individual as the beta of their portfolios differ. That means the investor, selling covered calls on a portfolio, is left with a "gut feeling", "seat of the pants" or some other approach instead of 25 years of data and research that can be analyzed to their hearts content.

Round One: Goes to SPX. Data trumps guessing.

Now let's look at some of the problems associated with selling calls on multiple positions, versus SPX.

Let's say we have a crystal ball and know that SPX will go up precisely 2%, so we maximize our OTM call and lose no return.

Let's also say that we have a portfolio consisting of two positions and that our crystal ball tells us their combined return will be precisely 3% (after all, it was hand picked with winners). What strike do you set? Watch out---trick question. Let's say you picked a 3% OTM call for both positions and one position went up 5% and the other 1%. Your portfolio returned 3%, but your covered calls limited the return to 3% on one position and 1% on the other, for a net of only 2%. So, you had a winning portfolio, but your covered calls cut its head off.

Even worse, what if one position went up 7% and the other position lost 1%. The "portfolio" averaged 3%, but the calls limited the return to just 1%. If this hasn't happened to you, you haven't been selling covered calls long enough. And these are the problems using a crystal ball and knowing in advance your portfolio return.

There's always the possibility that an investor could have selected the perfect strike level each and every month, varying them from position to position as necessary. If anyone out there has that level of skill you certainly don't need any advice from me.

Now, I know these examples are one sided, but they are real. Anyone that regularly uses covered calls has experienced this at least once, and more likely, multiple times. I'm not saying this always happens, just that it does happen enough and it is a consideration every covered call investor needs to think about.

Round TWO: Goes to SPX. Your return is your return.

Now, let's take a closer look at the stock that has gone down 1%. When it's time to sell the next months OTM call, do you continue to sell the call 3% OTM, or do you go 4% OTM, to give room for a rebound. After all, you had your "head cut off last month" on one stock, do you want to run that risk again? Decisions, decisions.

What about the stock that went up 7% and was called away? Do you re-buy at this higher level, sell a call 3% OTM after the big run-up? or do you sell the call 1% OTM or even ITM? Are you chasing winners? More decisions, more guesswork.

Round three: Goes to SPX. No need to try to outguess the market. Just keep selling 2% OTM.

Let's take a look at option characteristics: 1) The bid/ask spread on SPX is generally much more favorable than most securities. 2) SPX, in particular is cash settled, eliminating some additional headaches and costs (note: SPY is not cash settled). 3) SPX has weekly options and more expiry dates which opens up many more planning opportunities. 4) SPX is much more liquid than many individual options. Execution time is enhanced as well as the likelihood of hitting reasonable limit orders.

Round Four: Goes to SPX. Pricing advantages.

What about flexibility? The strikes on many stocks, such as JNJ, MCD and PG can be apart by as much as 2%-3% of the stock price. You may not even have a choice of going 3% OTM, but must choose between 2.5% and 5%. Other lower priced stocks may have strike separation of as much as 10%. Now what do you do? With SPX, the strikes are less than four-tenths-of-one-percent apart. You can fine tune to your hearts delight.

Round Five: Goes to SPX. Flexibility and precision.

What about ease of use and costs? Hey, do I need to explain that managing one position a month is easier and less expensive than multiple, maybe 10 or 20 positions?

Round Six: Goes to SPX. Expense and simplicity.

I would be remiss not to point out that covered calls don't require margin and are readily available for IRAs and 401k plans. Selling naked calls is expressly prohibited in IRAs. As a work-around, investors could apply for a margin account in an IRA and sell call spreads rather than naked calls, but it does chip away at returns. The margin requirements would present some problems for investors, especially those that routinely leverage options or short stocks.

Round Seven: Goes to portfolio. You can't do what you can't do.

Last is the risk component. It is possible that the portfolio, when compared to the SPX moves in such a way that the SPX option loses relative to the portfolio options. This can really only happen if the SPX consistently exceeds its strike of 2% OTM while the portfolio grows less than that. This is likely to happen on occasion, but it should not happen frequently.

In this case the exposure is a comparative or relative risk, not an unlimited risk. The risk is created not by any inherent flaw in this suggested strategy, but, rather, a result of poor relative stock picking by the investor.

Round Eight: Goes to portfolio. Risk is risk.

Conclusion: You're the judge, you decide the winner.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I trade options on SPX and SPY