Although the S&P 500 is up more than 10% for the month of October, few would dispute the notion that we continue to sit in a sideways market. The European debt debacle is far from resolved, and the protests that began as "Occupy Wall Street" have spread across the Western world. As economic troubles and growing income inequality fuel public anger, uncertainty creates volatility and diminishes returns from global equity markets.
| YTD | -0.27% |
| 1 Year | 6.01% |
| 5 Year | -8.36% |
| 10 Year | 16.83% |
So what are investors to do? Over the past decade, it has become clear that the traditional long-only, "buy-and-hold" equity investment model only works during periods of high growth and low inflation - so certainly not now. Given the current economic conditions, the best investment strategy would be one that:
- Benefits from high volatility
- Incorporates hedging (providing protection against market decline)
- Generates income regardless of investment performance
Several options strategies meet the above criteria, but covered-call writing is perhaps the easiest and most applicable to everyday investors. This strategy involves purchasing shares of a stock or ETF, and then writing a call option against each 100 shares, granting the call buyer the right to purchase the shares at a given price on or before a certain date. This strategy benefits from volatility because higher volatility means higher options premiums; it incorporates hedging in the sense that profit from the sale of the call option increases as the underlying security decreases in value; and when the call option expires, it generates income from the option premium regardless of underlying security's performance. Here is a real example using the S&P 500 Index ETF SPY:
- Buy 100 Shares of SPY at $125 on 10/24/11
- Sell 1 SPY Call option, Strike Price $125, Expiration 3/30/12 at $8 per share
Now let's compare how this strategy performed compared to a long-only outright purchase of 100 shares of SPY on the same date:
| Profit/Loss from Covered-Call Write | SPY Price on 3/20/12 | Profit/Loss from Long-Only SPY Purchase |
| ($700) | $110 | ($1,500) |
| $300 | $120 | ($500) |
| $800 | $125 | $0 |
| $800 | $130 | $500 |
| $800 | $140 | $1,000 |
As you can see, the sale of the call option provides 6.4% downside protection, meaning SPY can fall 8 points (6.4%) and the investor will still break even on the deal. In covered-call writing, the option premium - in this case $8 per share - represents the amount of downside protection afforded by the strategy. If SPY is still at $125 when the call option expires, the profit is $800, or a 6.4% gain. Above $125, the profit is still $800, as covered-call writing is a strategy in which there is a maximum profit; this is because, beyond $125, any profit from additional rise in the stock price is negated by the increase in the value of the call option. If we wrote the call option with a strike price of $135, our maximum gain would be much higher, but our downside protection would be smaller (as the option sold cost $4 instead of $8). Conversely, if we wrote a call option with a strike price of $115, our maximum gain would be smaller, but the downside protection from the strategy would be greater (as the option premium would be approximately $17). The further away the expiration, the higher all options premiums are.
An important thing to keep in mind with this strategy is how much volume there is in the market for a given security's options; the higher the volume, the smaller the bid-ask spread, and the easier it is to trade. SPY options have significant volume, and thus are easier to trade; The Rydex S&P Equal Weight ETF (RSP) options, on the other hand, are very thinly traded and as such should probably be avoided.
Thus, covered-call writing is an excellent strategy for uncertain and volatile times like these. In utilizing this strategy, investors are willing to settle for a maximum gain on their investment in exchange for downside protection and the extra income generated by the sale and expiration of the call option. Given the current economic conditions, why wouldn't you write call options against your long positions?
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours.
