With many market commentators predicting meek returns on equities in the coming years, now seems as good a time as any for investigating the potential of a covered call portfolio. The promise of the covered call strategy is greater returns with less volatility (and who wouldn't want that?). But, in practice, are these promises realized?
Three Strategies for Comparison
The most comprehensive historical performance data available on covered call strategies is from the Chicago Board Options Exchange (CBOE). Here we will look at two indexes published by CBOE with data going back to June 1988:
BXM - An S&P 500 covered call index in which at the money SPX calls are sold against a portfolio of the S&P 500.
BXY - Similar to BXM except that instead of an at the money call, a 2% out of the money call is sold.
For comparison purposes, the long stock portfolio will be:
SPTR - S&P 500 Total Return index in which dividends are continually reinvested.
The following charts compare three portfolios started with $10,000 in each strategy.
Portfolio value on 1/31/2012
As the data shows, the covered call strategies do outperform the benchmark, but in the case of BXM that outperformance is quite small. As late as August of 2011, the SPTR was outperforming BXM over the 20+ year period, so it would be difficult to attach much significance to the nominal outperformance of BXM over SPTR. BXY on the other hand does appear to perform favorably in comparison to the other two strategies.
The real advantage of the covered call portfolios is in the lower volatility. The data indicates that selling at the money calls reduced the standard deviation of the portfolio's annual returns by about 50%. Considering the comparable returns, this is quite promising. It suggests that one can achieve approximately the same returns, but with less volatility by selling covered calls.
The reason for the lower volatility of the covered call strategies is that in a down market, option premiums offset losses incurred by the underlying equities. Conversely, in an up market the losses on the short calls offset some of the gains made by the underlying. When the markets are trading flat, covered call portfolios tend to outperform as options premiums are collected but not offset by losses in the underlying or from the short calls themselves. This is demonstrated in the following chart which compares returns of the three indexes by year, sorted by SPTR returns.
Annual Returns Comparison
One of the limitations of CBOE's covered call indexes is that they neglect to include transaction costs and taxes. In a portfolio that requires trading every month and will often generate short-term capital gains, these added expenses can add up.
The ETN Approach
The simplest way to implement a covered call portfolio is through the iPath CBOE S&P 500 BuyWrite Index ETN (BWV). The benchmark for this ETN is CBOE's BXM index and it has done quite well at tracking its benchmark, trailing it by about the .75% fund expense ratio.
Unfortunately, there currently is not an ETN available to track the BXY index. With the proliferation of ETFs and ETNs, this may change in the near future, but for now, the only way to implement an S&P 500 out of the money covered call portfolio is directly.
The Direct Approach
Either covered call strategy may be implemented directly by purchasing stocks of the S&P 500 and selling the appropriate SPX call on a monthly basis. This is probably the least expensive approach because commissions on SPX options are relatively low and are settled in cash, minimizing transaction costs. This approach also offers the greatest flexibility in which option is sold (i.e. at the money, in the money, out of the money). One caveat is the generally large bid/ask spreads of the SPX options markets. Care should be taken to achieve fair prices when executing orders in wide markets.
Many small investors may have difficulty using this approach because of the size of SPX contracts. At 100 times the S&P 500 index, just one contract would require a portfolio of about $130,000 in underlying equities. Smaller investors could achieve similar results by purchasing the SPDR S&P 500 ETF (SPY) and selling its calls. In this approach, each contract would require about 1/10th the initial capital as the full size SPX calls.
A major caveat to this approach is that trading expenses could be much greater. Commissions vary greatly by brokers and individuals' trading activity, so it is difficult to say how expensive it would be to implement a covered call portfolio using SPY. Some things to consider are:
- the need for more contracts (and thus more commissions)
- larger fixed fees as a percentage of trade value
- the need for closing transactions (SPY options are not settled in cash)
- the expense ratio of the ETF itself
Although a covered call portfolio may not generate higher returns over a long period of time (20+ years), the evidence is strong that they do provide much lower volatility. Lower volatility combined with performance in line with equities in general make the covered call strategy very compelling indeed. When coupled with a macro outlook for low returns in equities over the next several years the case for a covered call portfolio is even stronger. This is precisely the type of environment that a covered call portfolio performs best in. Now may be the best time to implement such a strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.