Options trading has exploded in popularity over the last 20 years, and it's not hard to see why. Options provide greater flexibility to investors, allowing them to precisely tailor the risk they choose to take to their investment preferences. Do you want a trade that can return 10x in a month? Options can make that happen for you. Do you want to sell options against your portfolio to generate income? Options trading can do that for you also. However, with so many choices, it's easy to get taken advantage of or end up taking unintended risks. In this article, I'll show you key points of options theory, and provide some links to papers if you want to go deeper.
1. Options tend to transfer wealth from buyers to sellers
The theory is a little conflicting on this, but most researchers agree that collectively, options buyers get worse risk-adjusted returns than options sellers. This effect is known as the volatility premium. Here's a PIMCO study on what the volatility risk premium is, and how they profit from it. PIMCO has great research, for those willing to do the reading. Simply put, the volatility priced into options contracts tends to exceed the actual volatility experienced by 1-2 percent per year. As such, if you manage your positions correctly, you can profit an additional 1-2.5 percent per year using options if you take as much risk as the market, as you can see from the graph below.
However, what makes this tricky is that to profit from the volatility risk premium, you must take risk. The risk you're taking is that the market moves faster than you can react, and you are unable to hedge your positions. When you hedge your exposure to the underlying created by a position in options, it's called delta hedging. While it's true that writing options transfer risk at a price favorable for the sellers, taking equity market risk also transfers wealth from shorts to longs over time. The trick to profiting from options is to put yourself on the right side of both of the risk premiums.
Another point to take note of is that while hedging has costs, not hedging means that investors increase their equity exposure when stocks go down and decrease their exposure when stocks go up. This may sound attractive to some of you reading this, but it's a pointless form of market timing that has little to no benefit but loads of volatility. My guess from doing prior research is that increasing equity exposure when stocks fall is the culprit of the poorer returns. Ever heard the old trader's expression to "never catch a falling knife?" It turns out that this expression is right more often than not, given amount of literature on the risk-adjusted returns for buying in rising vs. falling markets.
To this point, hedging aims to keep your equity exposure constant to whatever target you choose, rather than let the market decide how much risk you take. This means as stocks rise if you're hedging you buy more as stocks go up and sell them back if they fall. As long as the volatility priced by the options exceeds the actual volatility experienced by the stock, you'll earn a profit from doing this.
An interesting side note is that while all options tend to carry a risk premium to the seller, index options tend to be more overpriced than options on individual stocks. The research is pretty dense to read on this effect, but people who profit from this are called dispersion traders. While some authors who used small sample sizes found that there wasn't a reliable risk premium for covered calls on individual stocks, larger studies with better data collection techniques have found that there is indeed a risk premium for selling options on individual stocks. Here's the best study I've found on this co-written by a former University of Texas graduate student if you're interested. Their key takeaway was that covered calls work best on indexes and on volatile stocks. This runs contrary to the perception of the covered call investor as a conservative retiree owning safe stocks. Call options on low volatility stocks may actually be underpriced, meaning investors have no incentive to sell them.
2. Covered Calls Have a Unique Risk-Reward Profile
A lot of brokers are under the impression that selling covered calls on positions increases returns. This is wrong. Statistics on covered call returns clearly show that covered call positions have lower returns and lower risk than uncovered stock positions.
Here are some statistics on covered calls from AQR, the large asset management firm in Connecticut. BXM is an index representing monthly covered calls, and BXY is 2 percent out of the money monthly covered calls. The source paper is a gem on options theory if you're interested. Returns are quoted in excess of the cash return.
As you can see, covered calls have lower returns than their underlying stocks do, but have a better risk/reward if you can be bothered to manage the underlying equity exposure. Other research I've found shows that you maximize your profit after transaction costs if you rebalance positions about once or twice per week.
Since transaction costs are an issue with covered call strategies, you need to be at a broker that supports your trading with low costs and have a six-figure account to do this right. Interactive Brokers is the kind of broker that could support this strategy, most retail facing brokers could not. Also, you need to be able to do the math to balance transaction costs against extra risk from ignoring moves in the underlying. You literally can't pay over $1-2 per trade or you'll lose all your alpha.
Source: Artur Sepp's Blog
As there are 252 trading days in a year, the X-axis represents the number of yearly rebalances. You can choose to rebalance anywhere to the left of the peak, hence how I arrived at weekly rebalances (twice per week if the market has experienced unusual volatility). The P/L on the Y-axis is how much extra you can profit from the strategy. The answer is that you can profit an additional 2-2.5 percent per year off of the strategy if you're willing to spend about an hour a week rebalancing.
Also, if you're curious about which options to sell, the short answer is slightly in the money calls and puts, with 1-2 months until expiration. The long answer can be found here, in another AQR study.
The issue with selling in the money calls and puts is that you are reducing return and risk, so you need to take larger position sizes to beat the returns on your old portfolio. This can be accomplished by allocating less money to other strategies, like bonds, or with the moderate use of leverage.
Another interesting thing I learned from my research is that August may be a bad time to trade options because so many market participants shut down trading in late July and don't come back until Labor Day. August also seems to be unusually prone to flash crashes and market anomalies. I guess it's not a bad time to cut risk and hit the beach!
3. Covered Call ETFs are bad products
It's possible to invest in covered call strategies through products like PBP, also known as the covered call ETF. However, when you look at the returns, the ETF is underwhelming. I wrote an article last August about PBP, where I criticized the high fees, inefficient tax structure, and high transaction costs imbedded in the fund. I've learned more options theory since then, so this is the update.
Here are the results for as long as PBP has been on the market. PBP is blue, the S&P 500 is red.
If you look, you'll see that PBP did worse than the S&P 500 on both an absolute basis and a risk-adjusted basis. It also underperformed its benchmark, BXM, by about 1 percent per year.
Why does the theory conflict with the published results?
1. BXM does not hedge, and as such, ends up with a fluctuating amount of equity risk, for which they get zero compensation. International stock ETFs have a similar issue with currency exposure but in a way that is less certain to be bad, but still annoying. In both cases, periodic hedging produces superior results for those willing to pay attention to their portfolio.
2. The index funds are likely manipulated by Wall Street banks to reduce the amount they have to pay to institutional investors they have swap contracts with. See the "Goldman Roll" for more. To avoid this, you would need to roll your positions before the index funds do and sell into them. This greatly improves returns in commodity indexes, but you need a calendar to keep track of the monthly rolls.
3. PBP charged 0.75 percent per year in fees to investors.
For whom do covered calls work?
1. Sophisticated investors who are able to hedge positions in index and futures options and willing to use leverage. This task just got a lot easier thanks to the new heavily traded and retail-accessible E-micro futures, which debuted in May on the CME.
2. Investors with positions in highly volatile stocks. Additionally, stocks that are heavily shorted give opportunities to profit from some other key pieces of options theory that I wrote about last month. Options dramatically improve the risk/reward of heavily shorted stocks, due to the fact that brokers rarely share short borrow fees with clients.
For whom do covered calls not work?
1. Your typical retiree probably shouldn't use covered calls, due to the complexity of managing risk and hedging.
2. If you aren't willing to use leverage, you can't eat with your better risk-adjusted returns, so they aren't of much use for you.
3. As such, if you're normally a buy-and-hold investor, options will create taxable income. If you have mark-to-market investments like futures and want to trade index and futures options, this doesn't matter to you because everything is consolidated to one P/L for tax purposes.
Trading covered calls on highly volatile and popular stocks is a solid strategy for traders. You also can make great returns selling ITM call options on certain equity and commodity indexes with high volatility. Since there are market regimes when covered calls do poorly compared with normal stocks, the strategy is best kept to roughly 25 percent of your portfolio's value, with the idea that you use covered calls to increase your gross equity exposure a little but sell options to get both a little less volatility and a little higher return. Covered calls don't work very well for unsophisticated investors, ETF investors, most retirees, and tax-sensitive investors. Knowing options theory helps you understand what you're getting yourself into if you trade covered calls.
Did you enjoy this article? Follow me for future research updates!
Disclosure: I am/we are long IVV. 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.