The Value in Covered Calls

One subject that gets less attention than it deserves is the value investors can extract from selling covered calls. To be fair, a covered call strategy sacrifices what can sometimes be considerable upside in exchange for a fixed return, but this can be a highly effective strategy in a range-bound market.

The chart below is a weekly chart that shows the CBOE S&P 500 Buy-Write Index (BXM), which is designed to replicate a buy-write or covered call strategy for the S&P 500 Index. Note that during the recent bull market, a buy-write strategy resulted in roughly the same returns as owing the SPX, but with less volatility.

More importantly, over the course of the last year, a buy-write strategy has significantly outperformed the SPX. The details can be seen in the next chart, where a relatively new ETF, the PowerShares S&P 500 BuyWrite Portfolio (PBP) has lost value at less than half of the rate of the losses in the SPX.

In sideways markets, in down markets, and even in up markets, a buy-write or covered call approach like that of the PBP, or first cousins (BEP) and (MCN), can be an excellent way to increase returns and reduce risk.

Comments

[H. T. Love:]

Being a new, but aggressive investor (sometimes trader), I quickly recognized the potential for writing covered calls. I don't do buy-writes because I do a little timing of my buys to get low prices. I then wait and write a covered call that has a strike price that ensures a profit (if the call is excersized) of no less than 2% and as high as 23%, depending on how good (lucky?) I was at timing the price movements of the underlying. The immediate profit from selling the call varies depending on if it's a stock I really want to keep for future profit/growth or one that I don't mind selling right away. For the former I write out-of-the-money calls, the latter in-the-money. I could do better if I could use the charts more effectively - that's coming with time, bruises (small ones so far, fortunately) and opportunities.

Rule 1: since I'm new at this, I only buy stocks I won't mind holding if the prices move the wrong way. Some big cap, some mid, some small. Diversified too.

Rule 2: If I really want to hold the underlying, I write slightly out-of-the-money longer-term calls (for a lower immediate return) for a longer time-frame. This works really well if I correctly guess a bearish trend (how could I miss that in this market?) with a short-term rally mixed in.

Rule 3: If I don't care about holding the stock, I'll write in-the-money near-term calls that yield a profit of at least 2% when the premiums plus strike are combined.

Rule 4: All costs are accounted for in my spreadsheets so that fees on both sides of all transactions are fully covered in the base cost and profit calculations.

Rule 5: No leaps. No contracts over 6-7 months in duration. This accounts for my trading in my IRA account wherein I can't close out a position without adequate cash. I try to keep about 20-25% cash available for short term trading or taking advantage of a real opportunity.

Rule 6: All equities that I intend to hold are used to write a covered call. So far, only one stock between the three accounts I manage is not underlying a call.

Rule 7: Don't get over my head (vis-a-vis experience level). No diagonals, butterflies, horizontals, strangles, ... yet.

Rule 8: Never write a strike price that does not yield a profit when combined with the premium. Further, if patience is available and the price trends appear favorable, wait to write the call until a profit resides in the strike price alone. Lower immediate return, but higher if exercise occurs (remember that 90% of calls are never exercised though).

Rule 9: Avoid closing out positions: it will eat your profits. Of course, if your pricing is right (not all that often for me) closing a position and writing another may be advantageous. But this requires more insight into the market's future activities than I feel I have now.

Rule 10: never regret the missed profit opportunity when you could have written for a much larger premium or strike if only ... Instead, revel in the consistent smaller profits that accrue over time through a disciplined strategy such as this one. Remember the saying "Bears make money, bulls make money but hogs get slaughtered".

This has also provided a small reduction in "book" losses (amount depends a lot on the "greeks") as I keep insisting on buying as things go down since I'm a long-term sort of fellow.

I hope that this is a valid strategy and may help some other "noob".

2008 Sep 09 03:02 PM

[Fred Thomson:]

This is a great article. Covered Calls has it's known disadvantages which the author points out very well. But a well disciplined covered call trading strategy can be very profitable and will beat stocks in all but the strongest bull markets. Also, any covered call trader will need some sort of tool to help him make decisions on when to manipulate his positions. A great tool can be downloaded at coveredcallcalculator....

2008 Dec 22 03:27 AM

[19709:]

Would you kindly email me a copy of the spreadsheet format you use to keep track of your trades, costs and profits? Thanks.

[e-mail]



On Sep 09 03:02 PM HardToLove wrote:

> Being a new, but aggressive investor (sometimes trader), I quickly
> recognized the potential for writing covered calls. I don't do buy-writes
> because I do a little timing of my buys to get low prices. I then
> wait and write a covered call that has a strike price that ensures
> a profit (if the call is excersized) of no less than 2% and as high
> as 23%, depending on how good (lucky?) I was at timing the price
> movements of the underlying. The immediate profit from selling the
> call varies depending on if it's a stock I really want to keep for
> future profit/growth or one that I don't mind selling right away.
> For the former I write out-of-the-money calls, the latter in-the-money.
> I could do better if I could use the charts more effectively - that's
> coming with time, bruises (small ones so far, fortunately) and opportunities.
>
>
> Rule 1: since I'm new at this, I only buy stocks I won't mind holding
> if the prices move the wrong way. Some big cap, some mid, some small.
> Diversified too.
>
> Rule 2: If I really want to hold the underlying, I write slightly
> out-of-the-money longer-term calls (for a lower immediate return)
> for a longer time-frame. This works really well if I correctly guess
> a bearish trend (how could I miss that in this market?) with a short-term
> rally mixed in.
>
> Rule 3: If I don't care about holding the stock, I'll write in-the-money
> near-term calls that yield a profit of at least 2% when the premiums
> plus strike are combined.
>
> Rule 4: All costs are accounted for in my spreadsheets so that fees
> on both sides of all transactions are fully covered in the base cost
> and profit calculations.
>
> Rule 5: No leaps. No contracts over 6-7 months in duration. This
> accounts for my trading in my IRA account wherein I can't close out
> a position without adequate cash. I try to keep about 20-25% cash
> available for short term trading or taking advantage of a real opportunity.
>
>
> Rule 6: All equities that I intend to hold are used to write a covered
> call. So far, only one stock between the three accounts I manage
> is not underlying a call.
>
> Rule 7: Don't get over my head (vis-a-vis experience level). No diagonals,
> butterflies, horizontals, strangles, ... yet.
>
> Rule 8: Never write a strike price that does not yield a profit when
> combined with the premium. Further, if patience is available and
> the price trends appear favorable, wait to write the call until a
> profit resides in the strike price alone. Lower immediate return,
> but higher if exercise occurs (remember that 90% of calls are never
> exercised though).
>
> Rule 9: Avoid closing out positions: it will eat your profits. Of
> course, if your pricing is right (not all that often for me) closing
> a position and writing another may be advantageous. But this requires
> more insight into the market's future activities than I feel I have
> now.
>
> Rule 10: never regret the missed profit opportunity when you could
> have written for a much larger premium or strike if only ... Instead,
> revel in the consistent smaller profits that accrue over time through
> a disciplined strategy such as this one. Remember the saying "Bears
> make money, bulls make money but hogs get slaughtered".
>
> This has also provided a small reduction in "book" losses (amount
> depends a lot on the "greeks") as I keep insisting on buying as things
> go down since I'm a long-term sort of fellow.
>
> I hope that this is a valid strategy and may help some other "noob".

Jan 23 01:28 PM