Do Covered Call Strategies Make Sense?

Includes: SPY
by: Reel Ken

Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. - Paul Samuelson

I constantly come across articles recommending covered calls as a strategy or to provide "extra income". The authors, contributors and commenters almost unanimously extol the virtues and report outsized gains. Quite frankly, my experience with Covered Calls is mixed and I was wondering if I was out-of-step or the sample is biased. As such, I thought it would be a good idea to look closely at the Covered Call Strategy to determine what really works.

First, let me state the obvious..… Covered calls clearly work in a down market (though selling or shorting works even better). The question that needs to be answered is do they work in an up-market and a normalized market that has its ups and downs?

Second, one can always "play" with strikes and achieve any comparative result, regardless of how the market moves. Since there are two indices readily available that track Covered Call strategies, one with at-the-money calls [BXM] and one with calls 2% out-of-the-money [BXY], I will restrict my analyses to these parameters.

Third, we need to differentiate between selling covered calls on an index to selling covered calls on an actual portfolio. Since the number and makeup of actual portfolios are unlimited, I'll just draw generalizations from experience.

Let's look at a graph of the S&P 500 (SPX) and the two Covered Call Indices Year-to-Date:

One can see that neither Covered Call strategy outperformed the S&P 500 . In fact the ATM strategy trailed miserably and the 2% OTM came closer. BUT I MUST CONFESS, this is not a representative graph. We all know that the market has been generally up YTD and one would expect a covered call strategy to underperform and is not representative of a longer-range commitment.

Let's turn to a more representative graph that covers a longer time period. In this case, I choose ONE YEAR, and I need to mention that a graph covering two years, three years and four years would look almost identical, so I think it is a more reliable benchmark:

As we can see, the ATM covered call strategy still lags while the 2% OTM strategy outperforms.

So, my first conclusion is that Covered Calls, 2% OTM are viable strategies whereas ATM covered calls are not.

However, these represent Covered Calls against the S&P 500 Index, not a portfolio of varied stocks. I wish I could provide a nice histogram for these cases, but that's impossible. Instead I must rely on logic, experience and, unfortunately, some bias.

Most investors would like to think their portfolios will outperform the S&P 500, but that is just not the actual result. For investors that underperform the S&P 500, selling naked calls on the S&P 500, even 2% OTM, could be a losing proposition. Let me give an exaggerated example to illustrate. Let's say that in a given month the S&P 500 rises 10% and the underperforming investor's portfolio only rises 5%. The 2% OTM naked call loses 8%, net, causing the portfolio to lose 3%, overall, whereas a true covered call against the S&P 500 would have gained 2%.

The reverse would hold true for the minority of investors that beats the S+P 500 and sells naked calls on the S&P 500.

I submit that most investors looking at selling covered calls wouldn't sell naked calls against the S&P 500 anyway; rather they would sell them against their actual holdings. This creates an analysis problem, but I'll do my best.

First, since most investors have mutual funds, how do you get a match for these? If you're enrolled in a company sponsored 401k plan, it may not be allowed. That means, for most investors, those that are left, we are looking at selling calls against, usually, a few selected stock holdings.

Now, when you have a few selected holdings (5, 10, 20 or so) the result will likely be very different than selling calls against a broad index. Typical, well performing, portfolios don't have every stock holding rising or falling by the same amount. There are outsized winners, neutrals and losers. The objective is to gain more on the winners than lost on the losers. No serious investor expects anything other than this.

That means, if the investor sells OTM calls against their particular individual holdings, they will lose the outsized gains on the winners and be left with the under-performers. This is not good investing strategy. Imagine if the investor tried this with Apple (NASDAQ:AAPL)---what a disaster!

Well, you say, the investor can just pick some of the lesser holdings with which to sell covered calls. That means they must differentiate between their better stocks and their lesser stocks. If they could actually do this, consistently, why not just "ditch" the lesser stocks and keep just winners?

So, I must conclude that a covered call strategy designed to fit a particular portfolio is likely to underperform.

Summary: Covered Call strategies can be useful. Certainly in a down market they provide some safety. In a rising or up/down market, selling covered calls OTM are preferred to ATM. How much OTM, I can't tell. I'm not willing to back-test all possibilities, especially when 2% OTM is already supported by analysis, reasonableness and my instincts.

But, and this is a BIG BUT, it presupposes a portfolio that will replicate the S&P 500. Many investors spend time and effort in picking their portfolio holdings and covered calls matching these particular holdings are not likely to work as well. They could "surrogate" with naked calls against S&P 500, but this really takes it out of the "Covered Call" strategy and into "hedging" strategies. That's another article.

Conclusion: In the end, 2% OTM covered calls on the S&P 500 seem to enhance portfolio performance. Maybe not as much as one would think, once transaction costs are factored in. But for most investors, those with individual holdings, whether such a strategy actually benefits them is questionable. Covered call portfolio gains are probably more resultant upon the investor's skill in stock selection, market timing, trend following and factors other than any inherent advantage in the Covered Call Strategy itself.

Disclosure: I 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.

Additional disclosure: I buy and sell options on S+P 500 Index