Although covered call writing is relatively common by income investors looking to boost returns, there are questions as to whether it actually improves long-term portfolio results. The premiums are tempting: the question is, do they compensate for the lost profits on share appreciation? Is the moderate amount of downside protection afforded by the premium received worthwhile?
This study is intended to provide factual background for an opinion on the desirability of writing covered calls on a selection of dividend paying stocks, as a method of achieving income above and beyond the dividends received.
The Index Evidence
CBOE (the Chicago Board of Options Exchange), in co-operation with Standard and Poor's, publishes a number of benchmark indexes that are intended to track or replicate common option strategies applied to the S&P 500 Index. Here are brief descriptions, excerpted from the website:
- BXM - The CBOE S&P 500 BuyWrite Index (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index. The BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index (SPXSM) "covered" call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.
BXY - The CBOE S&P 500 2% OTM BuyWrite Index (BXY) uses the same methodology as the widely accepted CBOE S&P 500 BuyWrite Index (BXM) but the BXY Index is calculated using out-of-the-money S&P 500 Index (SPX) call options, rather than at-the-money SPX call options. The BXY strategy diversifies the buy-write opportunities currently provided by the BXM. The BXY Index yields lower monthly premiums in return for a greater participation in the upside moves of the S&P 500.
PUT - The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.
Because the first two include the effect of reinvesting dividends, and it is always better to consider S&P 500 performance with dividends included, the proper comparison is between the listed benchmarks and the S&P 500 Total Return Index (SPTR).
The Chart above (click to enlarge) covers the period from 6/1/1988 to 3/31/2010, and was prepared from information made available by CBOE on their website. The SPTR returned 9.42% over the period involved, not too shabby, and food for thought for those who wish to compete against the index on the basis of fair comparisons.
PUT performance is impressive - 11.11% annualized. These are cash secured puts, with the cash invested in short term Treasuries. This evidence provides considerable support for income investors who elect this or similar strategies. The support for selling covered calls is less convincing, although BXY at 10.72% outperformed SPTR by 1.3%.
The index evidence does not provide a compelling reason to use covered calls as a continuous portfolio strategy. At about 1% per year, the slight theoretical advantage can easily be vitiated by commission expense, slippage on the bid/ask, dividend capture strategies, or a strong upward market. The strategy underperforms a rising market and outperforms a falling market. It does produce a lower standard deviation, for investors where that consideration is important.
Cash secured puts is a viable strategy. To me it's like being in the insurance business. The individual investor is selling insurance against market declines and making a steady profit. That will be interrupted from time to time by the market equivalents of hurricanes, tornadoes, conflagrations, or other catastrophes.
Stress Testing Options
Earlier this year, I spent some time developing a stress tester for options positions. The intention was to find a way to determine whether a variety of leveraged options positions would be safe for long term use over the complete gamut of possible outcomes. The spreadsheet developed can also be adapted to testing a low risk strategy such as the covered call to see if it can be expected to outperform over the long haul.
A spreadsheet was developed that is capable of doing random simulations of the S&P 500 index action, working with actual historical distributions of increases and decreases. Assuming beta determines the relationship of share price movements to the S&P, covered call options on individual companies were tested for 500 to 1,000 cycles to develop an expected rate of return under the full gamut of market conditions.
Experimentation suggested that the 2nd OTM (out of the money) call is better to sell than the 1st OTM. The 3rd OTM performed poorly, perhaps because the premiums are inadequate. Disregarding weekly options, the 1st expiration (near month) did not perform as well as the 2nd or 3rd expirations. For comparability between companies, the study used the 2nd OTM, 3rd expiration call as the point of reference.
Expected returns for the covered call strategy are very sensitive to assumptions about future market volatility. It performs best when the market trends upward in a relatively narrow range. To quantify this consideration, two market scenarios were used. In the first, labeled 0/101, the full gamut of historical increases/decreases, including the min and max, was used. In the second, labeled 5/95, results were limited to an area between the 5th and 95th percentiles.
The investor was assumed to buy 500 shares and sell 5 calls, selling at the bid and paying 9.95 a trade and .75 per contract commissions. Commissions detract from the strategy if only 100 shares and 1 contract are assumed. In my experience orders can be filled somewhere between bid and ask if done in any size.
Summary of results
Here is a table (click to enlarge), showing expected performance for a selection of dividend paying stocks under the two market scenarios describe above:
Examining the outliers, Prudential (PRU) has an extremely high beta of 2.40. The covered call strategy is unattractive for that stock, based on the model used. Verizon (VZ) pays the highest dividend of the companies included, and the covered calls show attractive expected returns vs. the S&P 500 under either market scenario.
Comparing the two market scenarios, the 0/101 outcomes don't provide much support for the covered call strategy. The 5/95 outcomes, in contrast, suggest the strategy would provide sufficient excess returns to justify its use, particularly if the investor picks his spots. If an investor believes that market action for the period of the position is likely to limit itself to an area between the 5th and 95th percentiles, covered calls will out-perform, with expected returns meaningfully higher than the S&P 500 index.
A Probability Cone
Expectations about future market volatility are the most important factor in determining the expected profitability of covered calls. To illustrate the importance, here's a probability cone for the S&P (click to enlarge):
If future movements will stay between the two blue lines, not inconceivable in a lower volatility environment, with anxious central bankers and dip-buyers poised to intervene, covered calls will be a fine strategy at today's prices. Further upside may be limited, in that the S&P 500 has doubled from the March 2009 bottom. It's also worth noting that the midpoint, shown in gold, slopes gently upward, ideal for selling covered calls.
Playing with the Variables
Commissions are a factor for small size positions. In the worst case, an investor who owns 100 shares and sells a 1st OTM/1st expiration call has expected returns that are inferior to just holding the S&P 500 index.
Beta and implied volatility are related concepts. However, beta is typically figured using long term experience, such as five years, while volatility is computed based on 20 or 30 days.
A company that has temporarily elevated volatility will look attractive for the covered call strategy, provided the investor believes the volatility will go back down. However, the elevated volatility may be a sign that something is in the works, making the sale of a covered call counterproductive. The investor may give away the upside to opportunistic and well informed buyers of short term calls.
If a stock has high beta, but the historical factors that caused it have been corrected, beta may overstate the rapidity with which the stock will move.
Prudential, as an example, has beta of 2.40. If that is an accurate predictor of share price movement relative to the S&P, covered calls can be expected to produce inferior returns. In the event of an extreme downdraft, the model pushes PRU down below zero. PRU didn't spend much time below 20 during the crisis. If the company has appropriately hedged its equity/variable annuity exposures now that the market is more stable, PRU may not be in any real danger during a down market and shares may be more resilient than previously.
Based on information developed, I question the sale of covered calls on an ongoing and indiscriminate basis. For investors who have the time and resources to develop an opinion on each individual case, a workmanlike approach applied to a conservative selection of stocks would probably add 2 or 3% to expected performance vs. the S&P over a long period of time. Investors who believe future market volatility will be relatively muted will reap good rewards selling covered calls, if their take on the market is correct.
Disclosure: I am long PRU, MMM, ITW, RTN, PG. I have no position in VZ. I'm long distant expiration, deep in the money calls on the other stocks mentioned, against which I have sold covered calls. I'm long SPY puts as a hedge.