Stop With The Covered Calls, Already

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Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Reel Ken
Summary

The objectives of covered calls.

The risks associated with covered calls.

Have your cake and eat it too.

Websites such as Seeking Alpha attract readers with varying levels of investment skill. I see everything from novice to extremely sophisticated investors. When I write an article, my purpose is always trying to raise the skill/knowledge level of my readers. I never present the "stock de jour." In order to educate, rather than recommend, I seek out areas that investors consider commonplace and try to expand the reader's perspective by providing views and analysis they may be unaccustomed to reading about elsewhere.

So it is with one of my favorite subjects - Covered Calls. Hardly a week goes by that doesn't include at least several SA contributors including in their article a suggestion, or recommendation to sell covered calls.

I appreciate that covered calls are routinely suggested as ways to add some income to a portfolio. Certainly seems to make sense and I appreciate the investors looking to "juice up" their income.

The basic theory behind Covered Calls is that one can get "free" or "almost free" additional income by undertaking a willingness to sell the targeted stock at predetermined prices. Most of these recommendations presume that the strike of the Covered Call will be sufficiently high enough that it will expire worthless and show net gain.

The theory goes a little further by concluding that even if some strikes are exceeded and the underlying is called away, the overall result will be a net plus... that is, the amount gained when they "win" the call-write will exceed the amount when they "lose" the call-write.

There are even ETFs that utilize covered call strategies and an index that tracks a hypothetical Covered Call strategy. Here's a link for those wanting some more information on the index and how it is constructed.

I can sum up all the statistics, math formulas and magic by simply stating the obvious: Covered call strategies will work in steadily falling markets, NOT work in rapidly rising markets and can be a real challenge in slow moving up/down markets, depending upon the level of volatility.

Here's a graph that can help in understanding of the "obvious."

Examining the graph carefully, we can note the following "Obvious" Conclusion:

1) From 2000 to 2003, a generally falling market scenario, the at-the-money (ATM) strike worked best compared to higher strikes (OTM).

2) From 2003 to 2008, generally modestly rising market, ATM and 2% OTM strikes were essentially equivalent.

3) It may not be too easy to notice, but in this same time frame, 2003-2008, most of the gains were in the early years, just before the turn from bear to bull. Thereafter, they pretty much just added small incremental gains.

4) From 2009 to the present, a rapidly rising market, ATM was a net loser, giving back all its gains and 2% OTM, essentially accomplished nothing.

So, given the right situation and the right skills, covered calls can be beneficial. That is not, to me, the issue.

It is my belief that covered calls, though enticing, are just not the most efficient vehicle to accomplish the stated objective. That, very simply, there is a better way.

I need to mention that for the typical investor using covered calls... that this article may, at first, stretch your comfort zone. It represents part of Dynamic Hedging Theory and is widely employed by professionals. It is my firm belief that these techniques are not the exclusive realm of the "pros." It is not beyond the abilities of the average investor... it is one of many techniques that can elevate the average investor.

Let me start by addressing, NOT my concerns, but typical investor concerns that routinely pop-up in comment sections when someone suggests covered calls.

Assignment Risk

Simply stated, the risk that the underlying stock will grow sufficiently so that it lands in-the-money and the call is exercised. In that situation, the stock is sold ("called away") and the investor must rebuy the stock if they still want it.

This is sometimes looked at as a positive... the stock is sold at a higher price. Of course, it can also be looked at as a negative in that the stock has its head chopped off and doesn't reach its full growth potential.

Taxes

There are two levels of taxes that must be considered. 1) Taxes (long or short term) on any stock "called away," and 2) the fact that net call option income is taxed as short-term-capital-gains (STCG) regardless of holding period.

Having to pay taxes on gains forced by a sale of the underlying is not necessarily of consequence if the investor would have sold, anyway. Of course, if they were just trying to gain income and the stock being sold will be rebought... even by waiting till it drops (if it does)... then the tax paid in the interim represents a real drag.

Paying income tax on call-writes just means one has made money... never a bad thing. The issue isn't that taxes are due, it's whether the taxes can be postponed or reduced through proper planning.

Strike, Durations And Underlying

It's easy to suggest to an investor to sell covered calls. Actually doing it requires some thought and planning. This is more complicated and I'll address some of the issues.

First, let me dismiss from consideration the investor that plays hunches, throws darts, rolls the dice, blindly follows a suggestion and doesn't really do their own research.

Instead, let's consider the reasoned investor. The investor that carefully researches which stocks to buy. The investor that sets criteria and adds or subtracts to their portfolio based upon solid fundamentals. In short, the type of investor most of us would like to think we emulate.

Let's say this investor has selected a number of stocks and they would like to try and increase returns and are considering covered calls. For simplicity, let's assume each stock, though in different companies with different characteristics, are equally weighted and each trades at $100 (I know that's fantasy land, but it makes things easy for me)

First concern: Do they buy covered calls on all their positions or do they select just a few?

Let's Say They Pick Just A Few

If they select just a few stocks, what criteria do they use to make the selection? Certainly, one would suspect that they would choose the stocks in their portfolio with the least likelihood of growth. Presumably, they would avoid covered calls on the "better stocks." Instead, they would write covered calls on the "good" stocks... you know the ones they picked but don't really "love."

I always wonder... why do investors have stocks they like and stocks they don't like in their portfolio? If one is so adept at the market that they can make this fine a distinction... between good and better... why don't they get rid of "good" stocks and just keep "better" stocks? Oh, well.

Just a query... let's say one owns Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN). Which one do they write a covered call on, and why? I can't answer, maybe someone else can.

One last consideration. If an investor has a widely diversified portfolio, say 10, 20 or more stocks and chooses just one stock to write a covered call... do they really benefit? That is, the statistical advantage to covered calls is that the more stocks that are included, the more likely that there will be winners and losers. If only a few stocks are picked, it is closer to "all or nothing."

Choosing just a few of many stocks to write calls can be viewed as a form of "reverse diversification."

Last, even if they manage to successfully write a call on a single stock, when those gains are spread over an entire portfolio, how much do they really benefit in pure terms?

Let's Say They Pick Multiple Positions Or All Positions

We need to pick strike prices for the covered calls. The lower the strike, the greater the premium received. Ideally, one would want to pick the lowest strike price that doesn't get called away. Of course, no one knows this in advance. How far OTM should one go? Lacking a crystal ball, and since 2% OTM may be a "sweet spot" let's go OTM 2% for each stock in our hypothetical portfolio with a strike at $102.

First, we must recognize that all stocks don't move the same amount. For instance, "A" may go to $103 and "B" goes to $101. Without covered calls, they "average" going to $102, but with covered calls, "A" is cut-off at $102 so they only "average" $101.50. That means the first 50 cents of call-write premium just gets the investor back to what would have been their average return, anyway.

Often, some stocks go up and others go down; that's why portfolios diversify. Imagine if "A" went to $105 and "B" went to $97. With covered calls at $102, instead of an "average return" of $101, they realize only $99.5. If "A" was a real winner and went to $110 the "average" return is only $99.5 instead of $103.5. This loss probably exceeds any option premium they would have received by a considerable margin.

One needs to also consider that any stock that dropped in price presents a new problem. Let's look at "B." Remember, we wrote a covered call when it was at $100 and it's now at $97. What strike do you now choose?

Writing a call 2% OTM, means a new strike of $99. That means if you're called away you realize a net loss of $1 from your initial set point. Not good investing acumen. Setting the strike higher means less and less premium. Meanwhile, your "A" winner gave up its excess appreciation.

Those with extensive covered call experience have learned that covered calls are easiest to handle when the underlying goes UP... but NOT so far UP, that it lands beyond the strike of the covered call.

Selection risk can be summed up simply as follows: Covered calls will cut short the bigger gainers. The net result is that the "actual return" of the portfolio will be less than the "average return" of the underlying stocks.

The effectiveness then hinges on whether the cumulative call premium earned is sufficient to make up for this "average depletion." There is empirical evidence that, done properly, and in the right circumstances, covered calls can be accretive to returns. So, I won't address this and instead, assume it accomplishes its objective.

So, We Have Three Problems With Covered Calls:

1) Assignment Risk

2) Tax Risk

3) Selection Risk including strike and duration risk

Let's Solve These Problems

Let me start by saying that I've heard countless rationales for the deficiencies I've just pointed out. They usually include... "I'd have sold anyway"; "I'll wait for it to drop and buy back in"; "taxes is the result of making money," etc., etc.

Aren't solutions better than rationales?

First, let's consider the investor that picks one particular stock to write a covered call on... say Exxon Mobil (XOM). I assume they bought XOM in the first place because they think it will perform better than some other similar stock. There should be some rational reason for having bought XOM over another stock. Actually, it should be safe to assume they bought XOM instead of an energy ETF because they believe XOM will perform better than its parent index.

Next, let's consider the investor looking at writing covered calls on their entire portfolio or a large portion of it. I would assume that the skilled investor has selected a portfolio of stocks that they believe will outperform a market based ETF, such as the SPDR S&P 500 ETF (SPY) or similar broad-based ETF. They may even own SPY and just augment it with some individual stocks.

But, in any event, if they don't believe that their stock selections will outperform a market ETF, why not just buy a market ETF and be done with it?

So, before one looks at covered calls, one must first decide whether the underlying stock or stocks just "happen" to be there or if they were carefully selected to outperform. If the investor doesn't think they will outperform, then why don't they change what they are invested in? Common sense, isn't it?

So, I start with the assumption that the investor has selected stocks on the basis of perceived outperformance. To do otherwise, would require an article encouraging them to abandon stocks and buy ETFs and there are more than enough of those floating around.

The Solution

Here it is: Simply do NOT write Covered Calls. Write naked calls on the appropriate INDEX. For instance, if one has a stock portfolio that resembles the S&P, write covered calls on the S&P by using the SPX or SPX Mini Index options. Let me emphasize that I'm not referring to options on the SPDR S&P 500 ETF but the SPX INDEX itself. Similarly, if the stock or portfolio more closely represents a Nasdaq or the Russell 500, then write a naked call on THAT index. A more complete list of Index Options including detailed explanations can be found on the CBOE website.

Now, what does this accomplish?

First, Index Options are cash settled. That means that there is no assignment... EVER. Your account is just credited/debited the net result of the trade.

Second, Index Options are taxed as IRC 1256 Contracts. That means that any net gain is taxed as 60% Long-Term-Capital Gains (LTG) and only 40% is Short term (STCG).

Third, since there's no assignment, stocks that appreciated will not be called away and you won't have a tax liability for them.

Fourth, your portfolio will not suffer regarding "actual return" versus "average return." Your winners will be able to run up as high as they can go.

Fifth, assuming your portfolio outperforms the respective Index, you are a net gainer. For instance, if you sell a naked INDEX call 2% OTM and your portfolio goes up 3% while the Index goes up only 2%, you keep that extra 1% index outperformance.

Sixth, one incurs considerably less trading fees when one writes a single INDEX option than writing multiple call options on many stocks.

What If There Is No Representative INDEX?

Let's look at the situation detailed earlier...looking to write a call on XOM. There is no INDEX that covers Energy. One can't get a cash-settled option with 60/40 cap gains treatment, but they can write a call on an energy ETF. It would require some more work than an INDEX Option...closing it out if ITM and a little more trading costs. But, if one prefers XOM over an Energy ETF, it would indicate that a call-write on the ETF is the better choice.

I'm going to throw out an advanced concept, but I won't get too detailed here. I just want to raise the curiosity level. Let's say one has decided that XOM is a better bet than another similar stock such as Chevron (CVX). As a result of your research, you own XOM and DON'T own CVX. Instead of a covered call on XOM, sell a naked call on CVX. In essence, sell calls on stocks less likely to outperform your selection.

What If I'm Invested In SPDR S&P 500 ETF Or Some Other Broad Based ETF?

This is probably the easiest situation one can imagine. In this case, there is a near perfect match with the SPX Index. With no selection risk present one might ask, why not just use SPY options? SPX still has several advantages:

1) SPX is cash settled and there is no assignment risk. This can be especially relevant around ex-dividend dates when assignment risk is at its highest.

2) In a taxable account, one avails themselves of the 60/40 cap gain treatment using SPX options instead of SPY options.

3) Many brokers (Fidelity is one) will allow investors to "pair" SPY and SPX options, so there is no margin impact.

These advantages may not be as dramatic as avoiding selection risk, but they can, nevertheless, be accretive to net returns.

Caveat

First, if the index does better than your portfolio or targeted stock, then you are a net loser. You are betting that your portfolio will, at least, equal the benchmark. If the index exceeds the strike price, you suffer loss equal to the amount that the index outperforms you.

Second, retirement plans don't permit naked calls. There is a "work around"... sell an Index Call-Spread with the upper leg very, very deep out-of-the-money. So DOTM, that it only costs a few cents. This will reduce your overall net gains, but not by much. On the other hand, it will be less costly than if one tried to write covered calls on just a few equity positions instead of the single INDEX option.

Third, Covered Calls do not reduce margin. Naked calls, or call spreads do reduce margin. This is not a concern for most typical investors. Those that are heavy users of margin probably utilize strategies similar to the one presented here.

Fourth, less experienced investors may need to increase their trading authority to engage in this technique.

Summary

Covered calls are widespread and commonplace. That doesn't make them the best choice.

Experienced investors routinely hedge positions using INDEX OPTIONS (or futures) rather than plain vanilla covered calls.

Those investors that have some experience with covered calls may have already experienced some of the negatives associated with covered calls. Those investors may want to expand their horizons and consider using INDEX Options instead.

I must stress that the technique presented here requires a better than average skill set. It represents a "step-up" from how most investors utilize covered calls. I cannot stress enough that investors should never undertake ANY investment or investment strategy without FIRST acquiring the appropriate skill/knowledge to understand what is portrayed.

There are many sources available to research these ideas. I recommend, as a starting point, the On Line and FREE Education Center at the CBOE. Here's a link (http://www.cboe.com/education/education-main).

Disclosure: I am/we are long AAPL.

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 have long and short positions on SPX Index options.