Use Covered Calls To Mitigate Downside Risk

| About: SPDR S&P (SPY)

Summary

Covered calls improve an investor's return in downside scenarios.

An investor who writes a covered call receives an upfront premium in exchange for giving up some upside potential in a stock or index that he or she owns.

There are certain scenarios and metrics that investors should consider before writing a covered call.

Writing covered calls is a sound strategy for investors who believe in the fundamentals of the U.S. economy, but have concerns about near-term fluctuations, weakness in China or falling energy prices. A covered call is a long position in a stock or index combined with a short call on the same security for the same number of shares. By selling a call, the investor receives some cash in exchange for giving up some of the upside in the stock or index. Therefore, the covered call investor's return in an adverse scenario will be better than the return for someone whose only holding was a long position in the stock.

The chart below illustrates a covered call position outperforms a pure long position in adverse scenarios. The chart displays the distribution of simulated total returns for four hypothetical positions of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) - a pure long position and three covered call positions with a range of strike prices. The returns in the below chart represent the output from 1,000 random simulations of SPY assuming a lognormal distribution with a mean of 9.5% and volatility of 11.6%. The simulation output has been sorted by the simulated so that the worst outcome for SPY appears at the far left and the best outcome at the far right.

Simulated Returns for SPY Long and Covered Call Positions

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Notice the significant difference between the green line and the light blue in some of the more unfavorable outcomes. This difference can be more than 7 percentage points. At the 25th percentile, the return for a pure long position of SPY is only 2% compared with more than 9% for a covered call with a strike price of 190. When investors write a near the money covered call position, they give up a significant portion of the upside in extreme favorable scenarios, but they lock in an attractive return in a wide range of outcomes.

Constructing a Covered Call Position

Identifying the stock(s) or index that you want to use for your long position(s) is the first step in constructing your own covered call portfolio. Your current portfolio is a good place to start, but you may want to consider stocks and indices that you do not already own. Any company that you believe has limited upside potential or significant downside risk (e.g. oil producer) is a good candidate for a covered call.

Once you have identified your long positions, the next step is selecting the strike price and maturity for each call. The ratio of the call price to the stock or index price, which we will call the call premium percentage, should be an important consideration because it represents the boost that writing a covered call will give your position when the stock or index does not exceed the strike price at expiration. The call premium percentage is influenced by the call's strike price, call's remaining time to maturity and the volatility of the underlying stock or index. A lower strike price results in a higher call premium percentage, but you are giving up more of the upside in your long position. The call premium percentage is positively correlated to time remaining until the call's expiration. The chart below shows the call premium percentage is much more sensitive to the strike price for calls with less time remaining.

Call Premium Percentage for SPY

Trading Volatility

The volatility of the underlying security is key driver of the call premium percentage; therefore, covered call investors should study it. Comparing the volatility implied by the call's price to the security's historical volatility can be helpful. The Black Sholes option pricing model will generate the call's current price if you set the volatility parameter in Black Sholes equal to the implied volatility. Many brokerages and Yahoo Finance include the implied volatility in their option tree display, which is list of the calls and puts that are available. You can find historical volatility for stocks and indices here. If the implied volatility is greater than the historical volatility, that is favorable for the covered call investor as long as there is not a good reason to believe the underlying security will be more volatile in the future than it has been in the past. For example, it would have been reasonable for the implied volatility of an oil producing stock to be greater than its historical volatility at the end of 2014 when oil prices first started falling.

Comparing implied volatility to historical volatility can help you decide whether writing a covered call is a good strategy. Below are two examples.

  1. You own shares in Wal-Mart (NYSE:WMT). You believe management's plan to bolster profitability will ultimately be successful, but you have concerns about quarterly results for 2016.
  2. You own shares in Pioneer Natural Resources (NYSE:PXD), an oil producer. You think PXD has competitive advantages in finding and developing oil fields; however, you are nervous about oil prices falling to $20 in 2016 before rebounding in 2017.

Both scenarios seem ideal to write a covered call that expires in early 2017. However, only one is a viable trade based on a comparison of implied volatility to historical volatility. WMT has historical volatility of 21%. Unfortunately, none of the options expiring in January 2017 and within 40% of WMT's current price have an implied volatility over 18%. Conversely, PXD has a historical volatility 39%, and lots of options expiring in January 2017 have an implied volatility greater than 45%. Writing a covered call on PXD seems like the better trade. Since implied volatility is low, you should consider buying a put for your position in WMT.

Comparing implied volatility can be a good way to select the right strike price once you have decided you plan to write a covered call on a specific security with a certain expiration. Suppose you own shares in the health insurer, Aetna (NYSE:AET). You believe the AET has a good long-term strategy and a management team with a strong track record of execution. However, you have concerns about how the elections in 2016 will affect the market's view of health insurance. Writing a covered call could offset some of the downside of an unfavorable outcome to AET in the presidential or congressional races. In the table below, the call with the strike price of $135 has the highest implied volatility, that means the Black Sholes option pricing model would consider this particular call to be the best choice among the options listed in the table. It is important to recognize that options with a very different strike prices will have very different risk and return profiles. Therefore, it is not a good idea to use implied volatility as the sole factor in deciding among options with a wide range of strike prices.

Strike

Bid

Implied Volatility

135

8.75

28.8%

140

7.05

28.2%

145

5.80

28.1%

150

4.65

27.7%

155

3.70

27.4%

Click to enlarge

Special Situations

Covered call writers need to understand how certain events can affect option buyers' behavior. Otherwise, they may underestimate the maximum possible return of a position, the probability of achieving that return or the probability of the long position declining. Below are some examples of a few special situations.

Large Dividends

After the ex-dividend date, a stock should trade lower by the amount of the dividend all else being equal. This fact has two implications to covered call writers. First, they should expect to receive less premium because call buyers will incorporate the impact of the dividend into their analysis. More importantly, covered call writers may not receive the dividend. Retail investors will almost always trade American options which can be exercised at any time. Suppose an investor owns a call option on Verizon Communications (NYSE:VZ) with a strike price of $50. The option is expiring on Friday, and VZ's ex-dividend date is Thursday for a dividend of 56 cents. VZ is trading at $50.25. In this scenario, the investor may decide to exercise the option on Wednesday. Then, the covered call writer would not receive the dividend. Exercising an option early is very rare because the optimal strategy for the option holder is usually to sell the option, but it could be difficult to find a buyer in certain scenarios involving large dividends.

Earnings Announcements

A covered call writer should not compare implied volatility to historical volatility for short dated options when a earnings announcement or other major company event is imminent. In this scenario, implied volatility will likely be greater than historical volatility, but that does not necessarily mean the option is overvalued. It is reasonable for investors to expect more volatility in the stock ahead of an earnings announcement.

Macroeconomic and Industry Events

Events that impact the economy, such as a Federal Reserve announcement or national election, can also inject volatility into a market. Another example is supply and demand reports for commodity producers especially when the commodities pricing has been volatile. For example, oil companies' stocks have been fluctuating violently after press releases by the U.S. Energy Information Agency (EIA) depending on how the EIA's data compares to expectations. Concerns about Federal Reserve actions, political risk and industry issues can be very good reasons to employ a covered call strategy, but the covered call investor should think about the inherent volatility of these issues when determining an acceptable price for the call.

Downside of Covered Call Writing

As every seasoned investor knows, there is no strategy that can generate returns greater than the risk-free rate without taking risks. There are three elements that a covered call investor should consider carefully.

  • Writing covered calls does not immunize an investor from a downturn in the market. Suppose you own 100 shares of Apple (NASDAQ:AAPL), which is trading at $100 (as of this writing), and write a covered call for $4 with a strike price of $110. If AAPL falls to $90, the value of your shares of AAPL will decrease by $1,000. Your return will be better than an Apple shareholder who did not write a covered call because of the upfront payment for writing the call. However, your total return will still be negative.
  • The cost of writing covered calls can be expensive. A covered call investor will pay separate commissions to buy the stock or index and to sell the call. Brokerages also charge a fee if the call option is exercised. Furthermore, this investor will sacrifice the bid ask spread on every position which can be substantial. Most covered call funds will charge a load that is greater than a traditional stock mutual fund. Writing a covered call on a popular index is the lowest cost option.
  • Liquidating a covered call position can be expensive. An investor should be able to close out a covered call position by buying the call and then selling the stock or index. Some brokerages will allow you to do this in one order. However, the investor will pay commissions and sacrifice the bid ask spread for a second time.

Conclusion

Writing covered calls can mitigate the negative impact of a decline in a portfolio's long positions while enabling the investor to still generate significantly greater returns than a low risk investment, like a CD. This type of investment could be ideal for someone who has faith in the long-term prospects of the broader economy or specific securities but has concerns about short-term volatility. The upfront premium that a covered call writer receivers bolsters his or her return in scenarios where the stock's price does not exceed the call's strike price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.