Own the Stock and Sell Calls: Guaranteed Win, Right?

/Own the Stock and Sell Calls: Guaranteed Win, Right?

Own the Stock and Sell Calls: Guaranteed Win, Right?

By | 2017-08-18T16:59:31+00:00 June 24th, 2014|Research Insights|12 Comments

Covered Calls and Their Unintended Reversal Bet

Abstract:

Equity index covered calls have historically provided attractive risk-adjusted returns largely because of their joint exposures to the equity and volatility risk premia. However, they also embed exposure to an uncompensated risk, a naïve equity market reversal strategy. This paper provides evidence that the reversal exposure is responsible for about one quarter of the covered call’s risk, but provides very little reward.

Alpha Highlight:

The hunt for “yield” in this market is relentless. The big banks (e.g., Goldman Sachs, UBS, CS, DB, etc.), hedge funds, and now mutual funds and ETFs (examples here, here, and here) have been promoting the idea that buy write call strategies are the best thing since slice bread–get more yield without any real downside. The chart below, written by 3 Goldman Sachs employees and published in the Financial Analysts Journal, highlights the benefit–at least historically–of a strategy that is long stocks, but also writes calls along the way. The paper is well done and addresses the buy-write trade in a professional academic manner: highly recommended reading.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The story of buy write strategies is as follows: The big upside of buy-write is extra income and smoother drawdowns; the big downside (among others discussed below) of buy write strategies is huge underperformance during a bull market.

The chart below is directly from the CBOE website, highlighting the issue with big bull markets and a covered call strategy:

CBOE - Micro Site_2014-06-24_08-02-40

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Enter Equity Market Reversal Strategy Risk

The authors highlight that the returns to index covered call strategies are discussed in the context of 2 risk factors:

  • Equity premium: arguably low at this point in time.
  • Volatility premium: arguably low at this point in time.

But the authors bring up a new risk associated with covered call strategies that are rarely discussed:

  • Market timing risk

How does market timing risk work?

If you dust off your options textbook you’ll remember the term “delta,” which refers to how sensitive an option price is to the underlying stock price. For example, if you have an at the money call option on 1 share of the SP 500 and the option has a delta of .5, for every $1 movement, the option will move $.50 (approximately).

Now that we understand delta, we can understand how the call option we sell affects the covered call strategy.

  • As the index price increases, the delta on the call option increases because it is more and more likely to expire in the money.
  • As the index price decreases the delta moves in the opposite direction to reflect the fact it will likely expire worthless.

Because a covered call option strategy reflects an underlying position in equity (delta = 1) and being short a call with changing delta, we get the following situation:

  • Baseline situation:  S&P delta = 1 and short call position delta = -.5; net .5 delta
  • More equity exposure in a falling market environment:  S&P delta = 1 and short call position delta = -.25; net .75 delta, or higher market exposure
  • Less equity exposure in a rising market environment: S&P delta = 1 and short call position delta = -.75; net .25 delta, or lower market exposure

The above highlights in Barney-Style terms how this works and avoids extra complication associated (e.g., vega, theta, Gamma, Rho). In the end, a covered call strategy embeds elements of a reversal strategy, not a trend-following strategy. Unclear whether a reversal strategy or a trend-following strategy is dominant, but it is important to know what you are buying!

The authors decompose the returns associated with each component of risk associated with a covered call strategy. As the results show (examining the Sharpe Ratio below), the equity and vol premium are good bets, the equity timing component doesn’t produce.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So next time the peddlers are peddling the amazing power of covered call strategies as a great way to increase yield and print free money, ask them the following:

  • What is your opinion on volatility premium? Are you bearish on volatility and think VIX is steady and falling? Bearish volatility implies we shouldn’t do a covered call strategy.
  • What is your opinion on equity risk? Are you bearish on the market and think we have hit a permanent peak? Bearish on stock market implies we shouldn’t do a covered call strategy.
  • What is your opinion on equity timing? Do you like trend-following? Then we shouldn’t do a covered call strategy.

One must investigate these 3 return/risk drivers for a covered call strategy in order to make an effective decision as to whether a covered call strategy makes sense.

Have fun out there and always remember there are some really smart guys at AQR capital management competing against you in the marketplace!

 


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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • pretty much.

  • Doug

    http://www.hbs.edu/faculty/Publication%20Files/12-013_04998892-9027-47f8-aeca-717cbe49ad43.pdf

    Google “Jurek and Stafford” if the link is broken.

    Another short-vol strategy. Uses index put-selling. Much more sophisticated, as it adjusts the moneyness of the option and the leverage based on prevailing market conditions.

  • Thanks, Doug. Familiar with the study and actually highlighted that a few weeks ago: http://www.alphaarchitect.com/blog/2014/06/03/hedge-funds-destroy-investor-value/. Thanks for sharing, however. The paper is humbling.

  • Put selling does seem to work better than covered calls. It involves lower commissions (option instead of stock and option), bid-ask
    spreads are tighter without the concern of the exercise cost mentioned
    in the paper (stocks tend to go up, which causes puts to go out of the
    money with lower bid-ask spreads, but calls go in the money), and the
    volatility skew causes out-of-the-money puts to be more overpriced than
    out-of-the-money calls.

    It would be interesting to see the
    correlation between returns of the short-term timing bet (price formation period of
    1 month or less) and intermediate-term (3 to 12 month) momentum. If the
    correlation is zero or negative, this may strengthen the case for
    selling options if they are traded alongside a momentum strategy.

  • BXM vs. PUT vs. the underlying since 1986:

    PUT is more favorable than BXM in terms of CAGR, Sharpe ratio, and drawdown. BXM beats the underlying on the same three measures.

    http://mebfaber.com/2010/09/09/traveling-buywriteputwrite-and-mean-reversion-follow-up/

  • all good ideas/thoughts. Thanks for sharing

  • Some more thoughts:

    Delta hedging may be one way to minimize the bet on short-term mean reversion. Jared Woodard has a short e-book on iron condors where he finds that with transaction costs (buying at the ask and selling at the bid for all four legs, entry and exit), iron condors are not profitable. One-month condors are worse than two-month condors, presumably because transaction costs are higher with one-month condors.

    Interestingly, the two-month condors become profitable once a delta-hedge strategy using synthetic stock is introduced, despite the extra transaction costs involved (bid-ask spread for the put and call, entry and exit). He suggests that short term trends, such as a tendency for the market to rise during expiration week, make it difficult for the unhedged condors to perform well.

    Here’s a link to the book: http://www.amazon.com/Iron-Condor-Spread-Strategies-Structuring-ebook/dp/B004U7ML0Q/

  • thx for sharing!

  • Doug01

    http://www.businessweek.com/magazine/content/10_24/b4182044791082.htm

    “Trading options is one of the all-time sucker’s bets,” says Whitney R. Tilson, founder of hedge fund T2 Partners. “Most experienced professionals lose money doing it. It’s virtually certain that inexperienced, individual retail investors will lose money doing this.”

    I’m a retail investor, and I’ve spent a bit of time learning about options. My conclusion is that the vast majority of retail investors should stay away from them. There may be uncommon situations where they can be used to hedge risk. To obtain leverage in a tax advantaged account, where futures/margin can’t be used, they are a possibility. But with the exception of options on SPY, the implied volatility and bid ask spreads of deep in the money calls make them impractical. Finally, they can be used for income. But in a taxable account, I think you’d be better off after costs and taxes to sell some stocks, rather than using options. In a tax advantaged account, they may make more sense. They make more sense yet, when the market is highly valued, so the probability of a sideways market or a bear market is greater. But under those circumstances, I’d think you’d be better off seeking markets which are cheaper by value metrics.