Unmasking Covered Call Options by Anonymous, Sure Dividend
We are living in an era where generating income is not an easy task. Investors everywhere are struggling to squeeze a little more return out of their portfolios.
Combine this objective with a desire to reduce volatility and it’s no wonder that more and more discussion focuses on Covered Calls. The objective of this article is threefold:
- Discuss the mechanics of covered calls
- Discuss their latent shortcomings
- Offer a more practical alternative
I’m going to avoid highly technical and fully intricate explanations in order to accomplish these objectives without writing an article the size of a book.
I’ll try to keep it in the vernacular and deal more with concept than detail. In so doing, this article will represent a starting point for considered research by the investor. It is my hope that the reader will appreciate the nuance in covered calls.
Mechanics of Covered Call Options
A covered call is the process of writing (selling) a call against a particular underlying security. In exchange for selling the call, the investor receives a premium credit. Many view this as “additional income” when it really is just an exchange for any appreciation in the underlying stock that is above the strike price. It slowly converts to income as time passes and if the underlying remains below the strike. However, if the underlying climbs above the strike it slowly converts to an expense.
The call could be sold at various strikes and various expirations. The further out-of-the-money (OTM) the less premium received. The farther away the expiration the greater the premium credit received. There are literally hundreds upon hundreds of combinations. The first challenge an investor has is to determine which of those strikes and expiries is most efficient.
The optimal strike would be the strike that receives the maximum premium while giving up the least amount of growth. For instance, if the underlying stock was trading at $100 and grows to $105, the optimal strike would have been $105. If the strike was below that, say at $102, one would have received slightly more premium, but given up $3 in appreciation.
Of course it’s impossible to know in advance where the underlying will land at expiry, so this requires some skill and luck. Otherwise, the “additional income” can be completely offset by “loss of appreciation” or poor overall performance.
An additional consideration – and one understood by most experts – is that covered calls effectively change the dynamics of the underlying stock. Inasmuch as the call puts a “cap” on price appreciation in return for premium credit, it has the effect of moving a growth stock closer to a value stock and a value stock closer to an income stock.
So the first question I would ask any investor that was considering writing a covered call on a TESLA or AMAZON or any growth stock is this …
“If you cap the growth in exchange for income, why not just sell the growth stock and buy a value or income stock, instead?”
I do need to add that since the covered call lowers the risk profile of the underlying in exchange for growth, it also has the effect of reducing the volatility or Beta of the stock. This is because the premium credit helps in a decline. When you have less potential downside and less upside you have less volatility.
Shortcomings of Covered Call Options
Most people think of the shortcomings of covered calls as the possibility that the underlying will rise up rapidly and the stock will be “called away” with loss of appreciation.
I don’t consider that a shortcoming. It was part of the bargain. It was a calculated risk. When one takes a calculated risk and it doesn’t work, the shortcoming is not in the risk, but in the one making the calculation. If one drives recklessly and gets into an accident, it is not a shortcoming of the vehicle; it is a shortcoming of the driver.
There is a real shortcomings to covered calls. But it takes a little explaining. Here goes ….
Let’s say one has a portfolio of twenty positions and wants to increase yield via covered calls. They really can’t pick just one or two stocks; the effect would be minimal.
What procedure would one follow in picking just a few of their positions? If ABC is a candidate because it has less potential than XYZ, why not just sell ABC and buy XYZ?
One would never employ a covered call on a stock they favor, only stocks they don’t favor. So, is the process of choosing, itself, an indication that a portfolio overhaul may be more appropriate than a covered call?
For an investor to make a noticeable impact on their portfolio they would need to write covered calls on large portions of their portfolio. Only then would the cumulative premiums be significant and provide a reasonable level of “additional income”.
There is a concomitant increase in the effort to administer multiple positions. Not only are the costs increased but the likelihood of error becomes greater. Also, options are offered in 100 share equivalent lots. So, only round lots can be precisely “covered”.
Here’s The Real Problem with Covered Call Options
Lets’ say the overall portfolio grows in a particular month by 1%. Let’s also say the investor correctly predicted the 1% growth and wrote covered calls on every position 1% OTM.
Perfect… Or is it…
Portfolios that grow 1% are made up of positions that increased more than 1% and positions that increased less than 1% (or even decreased).
There may even have been a position that increased 3% and another that lost 1%. The average return of the two positions is 1% ((3%-1%)/2).
However, since there were covered calls, every position that increased more than 1%was capped and that “excess growth” was not realized.
On the other hand, the positions that increased less than 1% or lost remain. So, instead of the normal characteristics of the portfolio … winners and losers above/below 1% … the portfolio had no winners above 1%. The portfolio would have returned 1%, but after giving back the “excess growth” on some positions it actually underperformed itself.
The situation is even worse if the entire portfolio increased by more than the 1% covered call strike. What if it went up 2%.
Well, every position that increased more than 1% (and there must be many) is “chopped off” at 1% and every position that increased less than 1% remains intact. So, it is possible that the net return on the portfolio ends up less than 1%, when, without the covered calls it would have been 2%.
Even if the portfolio incurred a net loss, say 1%, there may well be stocks that increased and maybe even more than 1%. The same problem exists, just less severe.
Now, if anyone is so gifted as to be able to choose strikes and expiries on twenty positions where they sell each call at exactly the right strike to maximize premium credits and never get a strike over-run… Please, please contact me… I’d like to know what you’re doing.
Another shortcoming of covered calls is that many investors have positions in mutual funds and no one writes covered calls against mutual funds. This is not to be confused with mutual funds that get on