Win With Covered Calls Even in a Flat Market

Here’s a great article on covered calls. It explains what they are and when you should use them. They are usually a safe bet, and they generally make you money – even in a flat market. But there are times when they’ll hurt you. Read on to find out when that is.

The world is flat, or so people thought, until enterprising Greek philosophers challenged the notion in the 6th century BC. More than 2,000 years later, Ferdinand Magellan made a practical demonstration of that fact when he circumnavigated the globe. Although stocks in 2011 sailed through periods of sunshine, wind, and rain, many equities markets ended up flat just the same. Nonetheless, some investors proved that it is possible to make money in this market — and they did so writing covered calls.

Covered call writing is a strategy whereby the owner of a stock sells a call option that grants the right to have the stock “called away” at a certain price in the future. This strategy can also be done on many ETFs and indexes, as long as you hold an appropriate exposure to the underlying asset (the ETF or index).

Let’s take a look at how the strategy stacks up to my golden rule of options. This rule, learned the hard way, through two decades of profits and losses as a market maker on the options trading floor, consists of the following:

All option strategies have both positive and negative attributes. The key to using options successfully is to make sure the positive attributes are more valuable to you/your client than the negative attributes are detrimental.

This sounds like such a simple concept, but so many of us forget that for every buyer there must be a seller. If that is the case, there must be both positive and negative consequences to each trade. This is clear when buying a stock: the positive (making money as the stock price rises) is offset by the negative (suffering losses when the stock price falls). But this simple truth is often forgotten in the options markets due to the many moving parts, such as time decay, volatility changes, etc.

In the case of the covered call strategy, the positive is the premium you receive for selling the option. This premium may be large or small depending upon various factors, including the amount of time to expiration, the volatility of the underlying asset, and the option’s strike price compared to the price of the stock, ETF, or index. By the time of expiration, if the underlying asset remains below the strike price of the option, the premium is a positive collected by the option seller. (Don’t you dare think of this as a “free” dividend.) A negative occurs when, at the time of expiration, the underlying asset price has risen above the option’s strike price by more than the premium of the option. This is the positive and negative paradigm involved in covered call writing.

So now that we know that covered call writing often enhances returns but can also cap upside gains, how do we determine the past performance of such strategies? One way is to check out the BuyWrite Index (BXM), which shows how a passive options selling strategy on the S&P 500 index might have done. (Buy-write is another name for a covered call, because you buy the stock and write call options on it.) The index calculates a strategy that sells a one-month, at-the-money call option, waits for expiration (where the option is cashed out), and then sells another one-month, at-the-money option.

BXM Index

Sources: CBOE, Bloomberg

During 2011 the BXM Index returned 5.7%. Not bad for a flat market. By selling covered call options, the time decay in the position enhanced the returns.

What happens in a rapidly rising market? Well chances are you will underperform with this strategy. Remember, there is both a positive and negative aspect to all of these positions. But, overall, the BXM and strategies like it have outperformed market indexes with lower variability of returns.

By Bud Haslett, CFA

Go to Seeking Alpha for the entire article

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