Cover Call Writing
Before we discuss covered call writing, let's review some basics about option contracts. Options are standardized contracts traded on exchanges, and their values are derived by an underlying security or index. They are traditionally used to speculate or hedge the value of the underlying security. In our case, we use them to create a reliable stream of income. Many people are afraid of options because of their speculative roots and misunderstanding of how they work, but in our case a properly constructed covered call portfolio can actually reduce portfolio volatility or risk.
Two types of options contracts exist: puts and calls. All options have a strike price and a maturity date. Puts are used to speculate or hedge against the potential downward movement of the underlying security or index while calls do the same for upward movements. In a standard contract, one contract is equivalent to 100 shares of the underlying. Thus, options are a way to “leverage” the underlying, i.e. gain exposure to the underlying for a period of time with less money than buying the underlying outright.
Two parties are involved in an option trade, the buyer and the seller. Buyers of contracts have “rights” while sellers have “obligations.” Buyers of puts have the right to sell the underlying to the seller (who has the obligation to buy) if it trades at or below the strike price on or before the expiration. Buyers of calls have the right to buy the underlying at the strike price on or before expiration; sellers have the obligation to deliver or sell the underlying to the buyer. However, option contracts have liquid markets, and most contracts can be “closed out” before expiration, i.e. the buyer sells the contract on the open market at a profit or loss and vice versa for a seller.
Covered Call Writing
To obtain their right to buy or sell, the buyer of an option contract pays a cash premium up front to the seller. While there are numerous strategies like spreads and straddles to speculate on the movement of a stock or index, as a covered call manager our interest is capturing the premium income. We buy an ETF or stock, analyze the options available typically within the next 90 days, and sell a contract on all or a portion of the position. The premium we collect automatically settles into the money fund or bank sweep account within our clients’ brokerage accounts and is available to spend or reinvest.
Whatever the price of the underlying does until expiration, our clients keep the option premium. On days just prior to expiration, we are busy deciding what options make sense to buy back, “roll” (buy back and simultaneously sell another), or allow to be “assigned” or “called away”—purchased by the option buyer at the strike price. After expiration, we a busy deciding what options to sell again on existing positions and making re-investment decisions on assigned positions. Typically, we stagger expirations in client accounts so that we are usually always selling some options every month in all portfolios and, in the process, rebalancing asset classes on a monthly basis.
Selling option premiums provides some limited downside protection. Thus, a properly diversified covered call portfolio should outperform a “long-only” portfolio in down, flat, and moderately up-trending market conditions. Because we are capping returns for usually 30-60 days at a time, a covered call portfolio will underperform in strong up-trending market conditions.
Covered Call vs Long-Only Performance Comparison*
|Market Condition||Covered Call Portfolio||Long-Only Portfolio|
|Moderately Uptrending||Possibly Outperform||Possibly Outperform|
|* Assumes underlying securities of each portfolio are the same and closely track asset class performance.|
Because of these characteristics, we believe that a covered call portfolio is an excellent complement to a long-only portfolio for any type of investor, even those who do not require current income, because we are generating returns through the sale of call options during times when long-only portfolios are not.
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