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Covered Calls Get a Bad Rap

The covered call stock option strategy gets a bad rap sometimes when commentators complain, “the covered call strategy has limited upside potential return with the potential for large losses.”  For a covered call position, which is entered and not managed, the previous statement is true.  However, a managed covered call position can be said to have, “unlimited upside potential return with downside protection.”  The downside protection is limited, but a little downside protection is better than nothing.


Best Feature

The best feature of covered calls, which is often overlooked, is that covered calls can generate a return when the market does what is likes to do a lot which is basically nothing.  For example, consider the covered call positions entered for PowerOptionsApplied’s (PowerOptionsApplied.com) Palladium TradeFolioTM:

Covered Call Return vs. Long Return

Actual Results

As indicated in the table, the average covered call return of 5.6% was greater than the average of the long equity’s return of 4.2%.  It should be noted that both of these returns were far superior to the return of the S&P500 Index (SPX), which returned 0.03% over the same timeframe.


Downside Protection

As mentioned briefly above, an advantage of the covered call strategy is downside protection.  If instead a negative return were experienced for each of the underlying equities above, then the covered call would have outperformed a long position due to the downside protection provided.  The average downside protection provided by the covered call strategy in the case illustrated above was about 3.5%.  For example, if the underlying equities were to drop an average of 2% in price, then the covered call strategy would have returned a positive 1.5% on average.


Managed - Unlimited Upside

Mentioned previously, a managed covered call position has unlimited upside.  For example in the case of the SLX position, the price of the ETF had increased significantly and the covered call position had achieved the majority of its potential return.  As a result, on 11/11/2009 the initial call option was rolled to a higher strike and further-out-in-time call option, EZNLE Dec 57.  Rolling the position increased the potential return from 5.7% to 9.4%.  Even though the 9.4% was not as great as a long position’s return of 14.2%, it did provide some additional upside return with downside protection which a simple long position would not have provided.


Another Management Technique

Another method, which can be applied to covered call management, is closing a call option in the event the underlying drops in price and then selling a new call option after the underlying recovers.  This strategy was employed with the QLD covered call position.  On 11/3/2009, the price of QLD had dropped significantly and the value of the call option was negligible, so the call option was closed.  On 11/9/2009 when the price of QLD had recovered, a new call option was sold against QLD, which increased the potential return of the position about 1%.


Conclusion

Investors employing the covered call strategy should consider managing the positions, as this can turn covered calls from limited upside to unlimited upside while also enjoying the benefits of the strategy.


 

Disclosure: No positions in IYR UYM QLD KOL SSO SLX SPX.