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Selling covered calls on a portfolio of equities or on a concentrated position may offer clients incremental gains while reducing direct exposure to interest rate risk
May 21, 2012 — 3:33 AM by Guest Columnist Barry Martin, CFA
As recently as five years ago, three-year Treasuries offered a 4.5% yield, greater than today’s three-year Treasuries at 0.5% and still greater than today’s 30-year Treasury yield of 3.3%. As a result of near-zero short-term rates, investors looking for income through traditional vehicles, such as Treasury bonds, are now taking on significantly more risk in return for higher yields. See: Five steps to get your clients out of bonds and into alternative, low-volatility investments.
Consequently, this may be the time for advisors and their clients to look beyond “safe” U.S. government Treasuries and consider alternative solutions to meet income needs. One way in which advisors can diversify clients’ income allocation is to sell covered- call options on a stock or portfolio of stocks. See: Buy alternative investments and get over Madoff, especially as interest rates threaten to rise: columnist.
I recognize that writing covered calls is by no means a novel concept, but implementing a methodical call-writing strategy now can provide option premium income when yields are low and can continue to serve as an income strategy as rates rise.
When a call is sold, the buyer of that call pays a price — the premium — to the seller for the opportunity to buy the stock at the strike price up until the expiration date. If that option expires, the client keeps both the stock and the option premium (a realized capital gain). If the option is exercised, the client keeps the premium but gives up the stock. Or, the position can be closed by purchasing a call option with the same strike price and the same expiration. In this case, a capital loss realized by closing the option position offsets the appreciation of the stock above the strike price. Accordingly, the primary risk of a covered option strategy (versus simply holding the underlying security) is opportunity risk. See: 4 reasons to use options — and 4 more reasons why you should think twice.
Value proposition for covered calls
Advisors should consider the following value propositions of selling covered calls:
1. Covered-call writing can lower volatility on an existing equity portfolio or provide clients who are cautious about the stock market with a more palatable method of increasing equity exposure in their overall portfolio. A 2012 Hewitt EnnisKnupp study on the CBOE S&P 500 BuyWrite Index (BXM) over the period of June 1986 through January 2012 found that the BXM produced a return similar to that of the S&P 500 with about two-thirds the standard deviation.
Compound annual returns for all asset classes over the period of June 30, 1986, to Jan. 31, 2012. Compound annual returns depend only on the beginning and ending values of the indexes and the elapsed time period. The growth rate of 9.17% for the CBOE BXM indicates that a $1 investment at this constant rate would have grown to $9.43 since inception.
Annualized standard deviation for all asset classes over the period of June 30, 1986, to Jan. 31, 2012. CBOE BXM has performed in-line with the S&P 500 annualized returns while at a much lower level of volatility.
2. At negative real interest rates, equities may provide better protection against inflation vis-à-vis fixed-income investments. See: What plunging equity prices say about bonds as a hedge for stocks.
Given the value propositions of covered calls, why haven’t more advisors adopted these strategies for their clients? Two reasons: They don’t have the time, or they don’t have the training.
Implementing a call-writing program can be daunting for one account, not to mention when spread over multiple client portfolios. And many advisors are not only managing assets, they are also managing relationships and acquiring clients. For these advisors, time-intensive trading strategies have to take a back seat.
Nearly anyone can write a call option, but which option? There are no less than 54 standard call options one could write on General Electric. Implied and historical volatility data give valuable clues, but maximizing potential cash flow while minimizing call-away or opportunity risk is a balancing act that requires one’s full attention.
I have noticed that overlay strategies are, in fact, gaining momentum among more sophisticated advisory firms: firms which have the staff, the systems and the expertise to execute a covered-call-writing program or firms which outsource the work to a quality manager.
Overall, whether you adopt your own call-writing program or outsource to an outside manager, selling covered calls during a period of low interest rates can provide clients with an attractive income strategy uncorrelated to bonds and with less interest rate risk.
Barry Martin, CFA is a portfolio manager of Shelton Capital Management, a registered investment advisor with a long history of managing portfolio strategies using U.S. government securities, municipal bonds, multicap equity, and derivative strategies. Martin has more than 10 years’ experience utilizing covered options and currently manages Shelton’s Optima Separately Managed Accounts, customized portfolios enhanced with option overlay strategies.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD) Copies of this document may be obtained from any exchange on which options are traded or by contacting The Options Clearing Corp., One N. Wacker Drive, Suite 500, Chicago, IL 60606 (1-800-678-4667).
Any strategies discussed, including examples using actual securities’ price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement or recommendation to buy or sell securities. You and your client should review transaction costs, margin requirements and tax considerations with a tax advisor before entering into any options strategy.
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