After a recent article that I wrote here on Closed-End Funds (CEF’s) that apply the strategy of writing covered calls against their portfolio holdings, I received a number of interesting responses, comments, and questions. My overall impression is that many investors (and potential investors) are somewhat confused about the nature of this strategy. I also note that this strategy is one that a number of wealth managers are suggesting for their clients. I recently listened to a couple of pitches that emphasized the value of writing covered calls as a strategy.
The general concept of selling call options against your portfolio is just fine—it’s the fact that many people do not grasp the implications of this strategy that bothers me. In particular, I have now seen a number of articles and gotten the explanation from a number of folks that state that the premiums that you collect when you sell covered call options can be regarded as income and treated, therefore, like dividends. This is an enormous misconception and it likely to end in a lot of hard feelings when either (1) the market rallies, or (2) volatility increases. At first, I thought that I did not understand what was going on when I read proposals that treated dividend income and option premium as similar sources of income in the portfolio. I have now seen and heard this explanation a number of times --- I get what these managers are doing -- and the pitch is often patently incorrect. To treat dividends and option premiums as the same thing in looking at a portfolio is an apples and oranges comparison.
Dividends are earnings returned to shareholders—they are true income. Option premiums are not the same thing. When you sell an option, you are selling what is called a ‘contingent claim’ against your portfolio. This means that in return for the option premium you are paid, you have a future obligation to the option buyer to sell him your shares at a specific price. Dividends are income with no future claims. I thought of a nice example to show how ridiculous it is to treat option premium as pure income. Imagine if you pay your homeowner’s insurance on January 1, 2006. Does your insurer treat this as income? Of course not. Your insurer has provided you with a contingent claim. If your house burns down, they will pay you some money. The insurer is like the investor selling a covered call. The insurer/call seller receives a premium in exchange for the promise that can potentially be costly to fulfill (building you a house or buying back your stock). When you sell a contingent claim, you must keep most or all of the premiums you collect in anticipation of the day when you have to fulfill the claim against you. The insurer banks the majority of the premiums he collects as reserves against disaster and you, the investor, should bank the vast majority of the premiums you collect from your covered calls against the day when the calls are exercised. An insurer who treats collected premiums as pure income is committing fraud.
A slightly more complex fallacy about call writing strategies is that the option premium can be treated as income once the term of the option ends. Is this correct? The answer depends on whether you plan to keep pursuing this strategy. If you write a covered call, collect the premium, and do not have the option called prior to expiration---and then never do this again—the premium is income. If you plan to consistently pursue this strategy over time, the odds will even out and you cannot consider this as premium. To pursue our example, if an insurer closes its books and allows contracts to expire, any money left in reserves may be considered income. If the insurer plans to write more insurance, premiums on the books—including those left from prior terms—cannot be considered as income.
Insurers make money because they charge more than fair value for insurance. If they calculate that the actuarial fair value of insuring my home for a year is $2000, they charge me $2000+. The “+