The Great American Covered-Call Scam

Summary

• Covered call strategies are heavily marketed by financial advisors but fail to improve returns.
• Using buy-write/covered call strategies limits your upside and does a poor job of protecting against market crashes compared to bonds.
• Covered call strategies are disastrous from a tax standpoint.

Using a buy-write/covered call strategy is a common pitch from stockbrokers who promise their customers that they can boost their returns with little risk. ETF providers also offer covered call funds such as the Invesco S&P 500 Buy-Write ETF (NYSEARCA:PBP) to track the long-running fad. Both approaches are bad ideas. When you drill down into the data, selling covered calls dramatically underperformed a plain-vanilla S&P 500 (SPY) portfolio over the last 10 years, as well as the theoretical Buy-Write Index (BXM), which conveniently ignores transaction costs. Additionally, if you carry out a covered call strategy in a taxable account, you are in essence converting much of your tax-deferred capital gains into taxable ordinary income. This nearly doubles your tax-rate and destroys your returns in the process.

PBP

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YCharts

This is the price change for the S&P 500 versus the PBP over the last 10 years. The S&P 500 goes up over time, whereas the PBP goes pretty much sideways. To be fair, this graph ignores dividends and distributions, but even when you account for them, over the last 10 years, PBP still only returned 4.75 percent per year, versus 10.17 for the S&P 500.

But aren't options overpriced?

The thesis for buy-write funds and ETFs is simple. Research shows that options are somewhat overpriced compared to historical volatility. In theory, you should be able to use this to pocket market-beating returns by selling covered calls.

However, options pricing models ignore the fact that stocks (which drive options prices) are more likely to go up rather than down over time. This means that puts tend to be overpriced relative to calls, and selling calls without owning the underlying stock/index is likely a money-losing strategy over time.

This creates a paradox in options pricing. The prices for puts and calls need to be at parity, or arbitragers can make risk-free profits through synthetic positions. But all else being equal, if you could only choose between owning a put option and owning a call option on the index for the year, you would probably want to own a call option. After all, the index goes up 3 years out of 4 on average. In light of this, call options aren't necessarily as overpriced as the thesis predicts, even if implied volatility exceeds actual volatility over time. Also note that the options market has become more efficient over time, and volatility premiums have shrunk, but not disappeared entirely.

The best way to think about this is to separate the strategy into two buckets. The first bucket is the S&P 500. The S&P 500 has a positive but volatile return over time. The second bucket is selling at-the-money call options on the S&P 500. This bucket tends to lose money over time, cutting into the positive returns you make by owning the index (if you were making money from both buckets, the PBP would outperform the index). Because the two buckets move opposite of each other, doing a buy-write strategy reduces your risk, but also your return.

Covered calls are a tax disaster.

Where it really gets ugly is when you consider the tax impact. In order to pay the losses on the contracts, the fund has to deliver the stock at the lower contract price and go buy the stocks back at a higher price. This means that the fund makes virtually no money from long-term capital gains and a bunch of money from options premium, which is taxed as ordinary income. These combine to create a tax cost ratio of 2.09 percent over the last 10 years versus 0.67 for the S&P 500. The tax ratio means that taxable investors in the fund lost 2.09 percent of the value of their investment per year from taxes

After taxes, the PBP returned a measly 2.7 percent per year. Compare this to iShares Muni Bond (MUB), which tracks investment grade municipal bonds. MUB returned 3.94 percent over the last 10 years with a tax cost of only 0.18 percent per year. I wouldn't recommend buying PBP in a 401K either, but holding it in a taxable account is plain suicidal.

Is selling covered calls ever a good strategy?

It can be under the right circumstances. The time to sell calls is when volatility is high and likely to go down. Despite strong market gains in the late 1990s, covered call selling strategies held their own against the S&P 500, rising roughly 150% from 1995 through 2000 versus a 200% rise for the S&P 500 (ignoring taxes). When the market went south, covered calls outperformed nicely between January 2000 and January 2003. There were two reasons why covered calls did well during this period. The first reason is that volatility was higher. Over the last 8 calendar years, however, volatility has been low and markets have been rising. Therefore, calls are cheap, and selling cheap won't make you rich.

^VIX

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YCharts

The second reason is that equity valuations were objectively very stretched during the late 1990s so future returns were likely to be lower. The combination of high prices and persistently high volatility during that period resulted in better returns for covered call strategies and worse returns for plain-vanilla shareholders.

PBP did better than the SPY during the 2008 crash, but still experienced close 30 percent drawdown in 2008, when bonds actually went up! MUB finished the year close to 1 percent positive, and the Vanguard Bond Index Fund (BND) index fund was up 5+ percent in 2008.

Takeaways

Covered calls do best during a flat market, underperform during bull markets, and provide much weaker protection against sharp drops in the stock market than bonds do. As long as volatility remains low and stock prices keep rising, options premiums will stay low also, failing to compensate investors for rising stock prices. Covered calls are a nice tactic for active traders to take positions on stocks or a market environment but fail miserably as a blanket strategy over a full market cycle, both on a pre-tax and post-tax basis. If you want to be fancy with options in your portfolio, make sure the math backs you up. In the case of buy-write ETFs, the math certainly does not.

Author's note, August 5, 2018: Unlike the premiums from writing covered calls on stocks, some percentage of the distributions from the PBP fund may be taxed like futures contracts (60 percent long-term capital gains, 40 percent ordinary income). This partially mitigates the tax problem but does not explain the disastrous underperformance, fees and transaction costs of the fund. The Morningstar data on total tax cost is very likely to be correct; the taxation of these funds is complex and unfavorable, and the returns are subpar. That said, talk to your CPA or tax advisor for the full rundown.

Analyst’s Disclosure: I am/we are long SPY. 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.