The naysayers of the covered call strategy claim that a covered call (or buy-write, if you so desire) investor is not adequately compensated for the risk they are taking. However, many covered call investors consistently beat the market on a risk-adjusted basis. In this article, I want to break apart the covered call performance and offer a valuable tip so that you will be adequately compensated for risk.
Covered Call vs. S&P Total Return Comparison
First, to those said naysayers, I offer the following chart. This is a graph of a few of the CBOE covered call indexes vs. the CBOE S&P Total Return (data from CBOE site, but my spreadsheet can be found at my website by clicking here).
- Red Line: S&P Total Return (SPTR): seeks to mimic the total return of the S&P 500.
- Blue Line: S&P Buy/Write Index (BXM): "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 (SPX) "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. Please visit the BXM FAQ for more information about the construction of the index." (Click Here for CBOE Source)
- Purple Line: S&P 500 2% OTM BuyWrite Index (BXY): "The CBOE S&P 500 2% OTM BuyWrite Index 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." (Click Here for CBOE Source)
- Green Line: S&P 500 PutWrite Index (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." (Click Here for CBOE Source)
There seem to be a couple of interesting points to glean from this chart. First, the S&P Total return underperformed all of the other strategies. When I was in school, many professors and professionals that I spoke with seemed to love to gravitate towards the fact that (at the time), the market had performed relatively flat if you look at a ten year time span. Not so if you were using some of the other strategies listed here.
Second, the PUT index significantly outperformed its (supposedly) synthetic equivalent the ATM Buy/Write. There is a lot of discussion taking place regarding the reason for the large discrepancy. I found a research paper (click here for source) that gives the best explanation that I could find and believe:
- SPTR index has more up months than down months. Looking at monthly period between two consecutive option expiration Fridays, there are total 259 months in the period that the index data are available (from 6/1/1988 to 12/31/2009). Excluding months with less than 1% change (up or down) in SPTR, 134 months out of 205 were up, the rest 71 were down. Up-trending market is to the advantage of Put-Write that has a long bias, as such PUT index surpassed BXM in time weighted performance.
- Slightly out of money puts and calls are used in PUT and BXM indexes when SPX can not exactly match a strike price available at option expiration Friday’s close. As a result, volatility skew gives more premiums to PUT than BXM index
For this study I used the buy/write strategy because many people do not have the access or desire to trade naked options. As well, many covered call investors are merely looking to juice extra returns from their current long positions.
MethodMy method comes from actually quantifying my personal trades. I have been involved in covered calls for years now, and have done reasonably well. When I got into my academic career, I was constantly heckled and criticized for subscribing to a trading strategy that, in theory, did not outperform the market portfolios on a risk adjusted basis. So, I set out to figure out what made my results better than the academic calculated results.
Step One: Company AnalysisMy first step was to note that I only do covered calls on companies that I actually want to own. I always perform deep company analysis, including a read through recent quarterly and annual reports, a macroeconomic dive into the key revenue drivers and costs of the company, comp analysis, and finally a discounted cash flow model. If I felt that the company was undervalued, then I would continue on to step two. There are a host of articles, tutorials, and guides on how to pick a company, that I will defer to those sources for now. What I want to focus on is the second step.
Step Two: Premium and Return AnalysisNext, I want to make sure that if I sell the right to buy my security at a certain price, that I am getting adequately compensated. Considering that I have a positive outlook for the company, I usually do not do covered calls around major company product/service announcements or earnings. These events tend to cause a lot of abnormal returns, more often than not on the positive side. Next, I look at a histogram of returns based on the time to exiration. For instance, if there were 20 days until expiration, you would really only be concerned with how far the stock can move in 20 days. Of course, this is a historical study and as we have seen in the markets of late, anything can happen. However, a historical analysis is only a piece of making sure that you are getting a positive alpha. I am usually concerned with finding an out-of-the-money call that has a high enough premium that if the stock drops, the premium will have covered a good portion of the loss. On the positive side, I want to make sure that if the stock jumps, the premium plus the price appreciation up to the strike is a decent payoff. As an example for analysis, we will look at Baidu, Inc. (BIDU). I chose BIDU mainly for its volatility in the market, as well as the fact that the options have some decent volume. Here is the histogram for BIDU's stock price, based on a rolling 20-day return period for the last three years. An additional step that I think would be useful would be to look at only the returns from 20 days before each option expiration. I just lack the time at the moment. Here is the histogram: Just as a side note, the mean is 3.2%, with standard deviation of 14.8%. Of course, the returns are obviously not normal, with a serious left tail, so I like to use other measures as well. For instance, the percentage of positive returns is approximately 62%, while the average return of those positive returns was 12%. Another (free) tool I like to use is SamoaSky's Options Oracle. It gave me this chart: The little blue dots are the closest OTM call options expiring in October, priced according to implied volatility (Y-Axis). The highest line is the highest realized volatility, which basically shows that the call options are priced well above the highest realized volatility (a norm in the options world). The other lines are one and two standard deviation lines related to realized volatility, while the blue line in the middle is average realized volatility.
What would you do?Obviously, my trading actions would be determined by my overall strategy for the stock. SamoaSky's OptionsOracle also provides a probability that your option will end ITM, so I would also take that into account. The table below summarizes the ITM probabilities and returns, based on the assumption that we bought the stock at close on 09/28/2011: BIDU Last Price on 09/28/2011: 121.42
BIDU October Call Options, with ITM Probabilities
|Strike||ITM Probability||Call Price (Bid) <% Premium to Price>||Total Return if Calls Exercised|
|125||44.35%||$6.55 <5.4%>||$10.13 <8.3%>|
|130||36.93%||$4.50 <3.7%>||$13.08 <10.8%>|
|135||30.22%||$3.00 <2.5%>||$16.58 <13.7%>|
*Update, as I submit this, I realize that BIDU has dropped approximately 11%. However, the methodical analysis of covered call strategies continues to work, as long as you are aware of the risks (like a large drop in the stock). In any case, with 16 days to go, you may very well still get called out of one of the above strike prices, given BIDU's volatility.