The covered call is one of most common option strategies there is, but it isn't going to be right for every situation. It can sometimes be a sound strategy, and other times it might not be. What's important to understand is that the covered call does have significant history and academic research behind it, making it clear that it can be an ally for investors, even though it can also underperform a long-only approach in certain market conditions.
Here's a recap of the strategy. A covered call involves an investor being long shares of a stock or an exchange-traded fund, then selling a call option against 100 shares of the underlying security. The covered call can do a few things: 1) provide income from selling the call, 2) establish an exit point from a position, 3) lower the cost basis of the underlying security's acquisition and 4) offer a degree of protection during a downturn.
Those are positives. However, that doesn't mean selling covered calls is a way to guarantee higher returns or even positive returns on an initial position. As with all investing strategies, covered calls have to be understood well, for both their strengths and weaknesses, and deployed after the proper analysis has been conducted.
During a bull market, the covered call may be less than ideal compared with being simply long equity. The reason is that selling calls, even those that are out-of-the-money, exposes the investor to the underlying stock or ETF being called away when it rises above the strike price. This is the key tradeoff with the covered call strategy - while it does provide income, it simultaneously places a ceiling on potential gains. In other words, you can reduce your risk, but you will also reduce the opportunity for reward.
Let's take a look at the different sides of the covered call strategy to see what we can learn:
- According to a study titled, 15 Years of the Russell 2000 Buy-Write, a covered call strategy using 2% out-of-the-money calls, with one month to expiration, outperformed the Russell index alone, with lower standard deviation. However, the advantage didn't last using calls that were expiring in two months.
- Another study, The Performance of Options-Based Investment Strategies: Evidence for Individual Stocks During 2003-2013, examined 10 widely held stocks and various option strategies over the course of a decade. The study found that the covered call strategy could many times outperform long-only, but there's a caveat: The early exercise feature of American-style options meant that the strategy may sometimes lead to lower returns.
- Meanwhile, Hewitt EnnisKnupp found in a review of the Cboe S&P 500 BuyWrite Index (BXM) that, from 1986 to 2012, the BXM index had returns that were in line with the S&P itself, and with a decrease in volatility. However, in "sharply rising markets," the BXM generally underperformed the S&P. Since 2013, the BXM has trailed the S&P. Going back to March 2009, U.S. equities have rallied considerably, and the past few years also have seen a substantial increase in a number of high-profile, large-cap tech stocks, which has catapulted the market higher and had a significant impact on the index's growth. The result has been an equity market that outpaced a broad-market covered call strategy.
- The covered call can be and is widely used with individual stocks and a variety of ETFs, not just market index-linked ETFs. An individual security may have much greater volatility than the market overall, possibly providing higher income opportunities.
- Covered calls are not meant as protection against a steep market sell-off. They are primarily an income-generation tool. Different option strategies may be suitable for an investor worrying about a large-scale decline. A single covered call isn't intended as a long-term insurance policy that will be held through the market's peaks and valleys.
- At-the-money and slightly out-of-the-money calls may have larger premiums for an investor to collect, but they also bring greater risk that the underlying will be called away. Is losing the underlying stock or ETF to exercise always bad? Not remotely. If an investor has already captured satisfactory upside, and is looking for an exit, the covered call can be a way to close the position. Investors place sell limit orders all the time when they're ready to take profits - this is the lowest price at which they'll agree to sell. With a covered call, an investor still sets a limit but can get income in the meantime.
- Covered calls rightly can be seen as a type of strategic diversification. Remember that this is an income-producing strategy that involves selling. Going long an asset, whether stocks or bonds or anything else, always requires a capital investment.
- Selling calls could have tax implications, depending on your account. This can vary. That's why it's important that investors talk to an advisor and accountant to understand the potential impact to a particular portfolio.
- If an investor wants to change course after already selling a call, the position can be closed by buying the call back. Yes, it will cost additional money, but the investor will no longer have to worry about a stock or ETF being called away.
To be clear, covered calls will not be right for every investing situation. They are not going to outperform every index, stock or ETF over every specific timeframe, but they do have the capability to be an important part of a strategy. They're also not risk-free. Before selling calls, you have to do your homework and be clear on the potential positives, as well as the potential shortcomings.
As always, it is important to do your research, get educated on options and have a conversation with a professional who can assess your situation so that you can invest with confidence.
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Options involve risks and are not suitable for everyone. Individuals should not enter into options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, available by visiting OptionsEducation.org. To obtain a copy, contact your broker or The Options Industry Council at The Options Industry Council at 125 S. Franklin Street, Suite 1200, Chicago, IL 60606.
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