The story behind writing calls on your existing holdings is very compelling on the surface and very intuitive to understand. You have your holdings and you sell the right to buy that holding at some price above current market price to another investor in exchange for immediate cash. The idea is that if you write call options far enough out of the money so that they expire worthless the majority of the time you risk very little and gain a consistent source of income.
The strategy is very seductive because the benefits are easy to see and understand and they accrue immediately. The investor still benefits from their stock holdings appreciation up to the strike price just as they would otherwise, so psychologically it's easy to give up "extra future gain" for real cash right now. It's a bird-in-the hand versus future potential bias. It's difficult to value future potential but the cash is easy to count.
The other reason why the strategy is so seductive is its similarity to regular dividends in the mind of the investor. The limiting of gains is not treated as a loss in our heads so it's almost like enhancing your dividend yield for nothing. The investor treats it as a clear win-win strategy.
The last and most important reason why investors love writing covered calls has to do with a psychological bias that mostly everyone has. The nature of the human brain means that we are pre-conditioned to prefer immediate and consistent rewards over the potential of one time future gains. In addition, we hate losses and anything that causes losses. The small but consistent profit from writing covered calls means we get immediate satisfaction and our strategy is very quickly validated. The fact that writing the covered call in itself cannot cause us to actually lose money (defined as ROR < 0% for the investment period) adds to the appeal. If the stock loses money during the investment period the investor mentally assigns this loss to the stock selection not the covered call strategy. If we sell the covered calls sufficiently out of the money there is a 75-80% chance that we will get a real positive return out of this strategy even counting the loss of gain on the stock holding. This means the investor is very likely to get positive feedback on the strategy quickly while the possibility of negative feedback is very low. This drives him or her to continue the strategy for another period.
To summarize, selling covered calls is a high probability strategy that generates consistent income and is guaranteed not to cause direct loses. Investors gain significant psychological benefits from selling calls even if the financial gains are questionable. They feel good about their strategy. Why is it guaranteed to lose money then?
Whenever evaluating a strategy or tactic it's always important to isolate the benefit derived from that strategy versus what could be achieved without it. In the case of covered calls, the benchmark should simply be the return you could get from holding the stocks without selling covered calls. It is not enough to say that covered calls did not directly cause you losses, because if they limited your gains on your stock portfolio by more than you gained by selling them, then it's a losing strategy.
The calls I will focus on in this example will be SPY calls with a March 28 2013 expiry. When looking at the implied yield curve for SPY options, it is actually the most beneficial expiry term in that curve to sell covered calls but I have done analysis similar to this for various expiry terms and I get exactly the same conclusions. However, I certainly encourage the readers to check for themselves.
The next step would be to decide how far out of the money to sell the call option at. The trade-off is between the annualized option yield expected from selling the call versus how likely is the option to end up in the money. The annualized yield is relatively easy to calculate as is the % the option is out of the money. The SPY chain on Jan. 9, 2013 for options expiring on March 28, 2013 looks as follows:
I started at 154 because as I will show the payoff is actually worse the closer you get to the money. I also stopped at 160 because the options more than 10% OTM have bids of less than $0.10 and any tiny yield would likely be wiped out by transaction costs anyway. There are two relevant questions the investor should strive to answer:
1) The likelihood the price of the stock will end up above (Strike Price + Option Premium) by Expiry Date. If the stock price exceeds this number the investor would have been better off just investing in the stock.
2) The amount that the stock price is likely to exceed (Strike Price + Option Premium) when it does exceed it.
The best way to establish these probabilities is to determine how often (and by how much) in the history of SPY did it rise more than the (OTM % + option yield) on an annualized basis for investment periods equal to the number of trading days between now and March 28th. The following is the result of this analysis for all such SPY investing periods since 1990 (that's 5708 individual investment periods).
Expected return on sold call for Investment period
Expected annualized return on sold call
% profitable sold call periods
The statistics above illustrate why covered calls appear to be a great strategy while in fact losing money over the long term.
The right-most column in the above table shows how often an investor should expect to make money on selling the OTM call. It's clear that the vast majority of the time the writing of any of the above calls will in fact generate excess return as opposed to just holding the stock. As discussed above, this frequency of positive returns is what helps fool investors into thinking this is a good long term strategy.
The 2nd and 3rd columns from the right illustrate what the expected return on the sold call portion of the covered call position would be. It is the average of returns across all 5708 investment periods. To clarify, this doesn't mean that the covered call position in its entirety is expected to lose money. The stock appreciation will offset the loss on the covered call in the "losing" periods but the overall effect on the return (the additional benefit) from writing the call is expected to be negative. You would be better of just holding on to the stock and doing nothing else.
The underlying reason for this underperformance has to do with the 10-25% of investment periods when the stock price appreciates more than the strike price. When you write a covered call, you are in fact choosing a relatively low 0.32-2% yield 90-75% of the time for large underperformance versus buy-and-hold the other 10-25% of the time. In the long term you'd be better off foregoing the extra yield and instead taking full advantage of the low probability but high return investing periods.
Some of the readers may have noticed that as the strike price gets higher the negative expected return gets smaller. This may lead them to think that there is a point where the return does in fact turn positive. Unfortunately this is only the case in theory. There is a point at about 15% OTM where, in theory, you are virtually guaranteed to make money because the likelihood of hitting the strike price before March is close to 0%. The problem is that unless you are a market maker, the bid of $0.01 is not nearly enough to cover transaction costs.
There may be some readers who will say today may not be the best day to judge the effectiveness of this strategy because of low volatility or low option premiums. This is a valid argument but the point of this article is not to say that it's impossible to make money writing calls. In fact, as the stats above prove, you will make money the vast majority of the time. However, unless you have tested rules to determine when to write calls and when not to, you are going to lose money (in comparison with buy and hold) mechanically writing calls over the long run.
While the article and especially the example above focuses on the SPY ETF, the results are much the same across most broad market ETFs. This seems to imply that call options are actually systematically under-priced in the market, if not by much. In turn, what this may mean is that volatility is often underestimated when calculating call option premiums. There are some very good theoretical reasons for why this might be the case, but that's a topic for another article.