Covered Calls: No Free Lunch

Options are contracts that give their owners the right but not the obligation to buy (calls) or sell (puts) securities at a predetermined price (strike) at a predetermined period in the future.

If an investor is bullish on Microsoft (MSFT) when the stock is trading at $20/share, he/she could purchase calls and profit at options expirations week if the stock price increases above the strike price plus the price paid for the call. The options price consists of time value/time decay and an intrinsic value, which is the difference between the strike price and the current price of the security. Overall in quiet markets the time decay decreases the values of options. The time decay portion of the options price is sensitive to changes in volatility and could increase if volatility increases however.

Most investors believe that by selling covered calls or cash secured puts they could achieve additional income from the securities they own or plan to own. This additional return comes from taking on the additional risk of potentially exercising your options, which could hurt your total returns.

The S&P maintains two options indexes based off the S&P 500. One of them incorporates selling covered calls against the index, while the other incorporates selling naked puts against it.

The CBOE S&P 500 BuyWrite Index (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write (covered calls) strategy on the S&P 500 Index. The methodology of the BXM Index is based on (1) buying an S&P 500 index portfolio, and (2) writing the near-term S&P 500 "covered" call option, generally on the third Friday of each month. The call is held until it is cash-settled on the 3rd Friday of the following month, at which time a new one-month call option is written.

Ibbotson Associates tested the strategy of selling covered calls against S&P 500 for the 16-year period between 1988 and 2006. According to the findings, the buy write index returned 11.77%, versus 11.67% for the S&P 500 index. The buy-write strategy managed to slightly outperform the broad market with lower volatility, as defined by standard deviations. The standard deviation for the buy write index was 9.29%, which was much lower than the 13.89% volatility of the S&P 500.

Overall for the past 23 years ending in March 2009, the buy-write index did manage to slightly outperform the S&P 500.

The covered calls strategy typically outperforms the underlying in flat and weak markets, while under performing the underlying in strong bull markets.

The chart below shows that as a percentage of the underlying value, premium income on covered calls has ranged between 0.5% to 4.50% and averaged close to 1.70%/month. Investors who dabble in options often see that they could purchase a stock at $20 and then sell a covered call at the next strike for $0.50, which represents a nice 2.50% return. Investors then start projecting and annualizing these kinds of returns. As evidenced by the first chart, these premiums are simply a compensation for foregoing any gains beyond the strike price, while fully participating in any declines in the underlying prices. They did not lead to the generations of any excess returns with any consistency relative to the cumulative performance of the S&P 500.

There are several funds which employ covered call techniques on S&P 500 index. One of the longest standing ones is S&P 500 Covered Call Fund Inc. (BEP). Over the past 4 years it has had a total return of almost zero, despite the fact that it keeps distributing $2 in dividends every year.

Thus on average, it is safe to assume that unless investors possess above average timing skills, selling covered calls is no free lunch, despite what gurus and self proclaimed experts claim this “safe” technique to be.

Disclosure: None

Comments

[Ricard:]

Agreed.

My covered calls on INTC made me miss the rally from 16.

Oct 16 08:02 PM

[Tom Armistead:]

This is good informaiton. The decrease in volatility might be of interest to some investors who prefer more stable results. To me the fact that the long term record of covered calls over the S&P tracks the index at least shows that you don't do any harm by selling them.

Agree with Ricard, it is frustrating to sell covered calls and then have the stock make a run.

I continue to sell covered calls on a judgment basis, usually where there is enough volatility to provide a decent premium and where the result if called away is to sell the stock in the area of my target.

Oct 16 08:36 PM

[Brad Castro:]

I agree that writing covered calls strictly for income can be a problematic strategy because of the occasional big moves in the underlying stock. A big move higher and you miss out on a lot of capital gains. A big move lower and the premium you receive won't do much to protect you on the downside.

But you don't have to write calls on all your positions, and you don't have to write calls every month. If you instead approach covered call writing (and other conservative option strategies) as a way to enhance your long term investments rather than as a substitute for having long term investments in the first place, you can do quite well over the long term.

Investing in high quality, consistently profitable companies is the proven foundation. But if you can then find ways to safely generate (or lower your cost basis) even an extra 5-10% a year a year on those holdings, you'll dramatically speed up your investment results.

Unfortunately, covered call vehicles like BEP are too cumbersome and mechanical to ever stand a chance of outperforming anything.

Oct 17 10:01 AM

[biomedlives:]

I agree with the Wall Street saying "Let profits run, but cut losses short," and thus writing covered calls doesn't appeal to me in general.

Oct 17 01:24 PM

[NoBoB:]

BEP intends to wind down on March 31, 2010, five years after inception. Unless they intend to modify that plan, it may not be the wisest choice to pay a dollar in premium to NAV now, only to get that dollar back in December's distribution (likely as ROC), and then get cashed out at NAV in March.

Oct 18 07:35 PM

[StockData.org:]

I might add, if you strongly feel a stock you have is going to stay within a certain trading range (for whatever reason), writing covered calls works just fine to enhance your cost basis a bit.

Oct 19 11:42 AM

[Adonis:]

What about writing two covered calls, each for half of your shares, one with a strike below your cost basis, and one with a strike above? This way you are protected against a drop in the price, and if the stock runs you also capture gains from the higher strike price. If the stock doesn't go anywhere, you still make money.

Just a thought, still a theory, I haven't actually tried this yet....

Oct 23 09:54 AM

[PUNK:]

I write covered call spreads. So I get the income but if a big run happens I participate.

Oct 23 08:57 PM