There is an old adage that during a period of stock market uncertainty, cash is king. It’s not quite cash that’s king as much as cash flow. Income producing assets, whether they are high-paying dividend stocks, commercial real estate or even corporate bonds hold a special place in a high net-worth investor portfolio when the stock market is volatile and range bound, like it appears to be today.
It makes sense; if the value of an asset is not going up in the near term, it’s always preferable to earn income on the asset “while you wait” rather than nothing at all. For this reason, “covered call writing” has been a particularly appealing, not to mention effective, portfolio strategy during the past year.
A covered call is a call option sold for a premium on a stock held in one’s portfolio, which gives the purchaser of the option the right to buy that stock from one’s portfolio at a specified price, known as the strike price, over a specified period of time.
If the stock appreciates beyond the strike price, the buyer of the call can exercise the option to purchase the stock at the strike price. An investor who chooses to utilize a covered call strategy will limit some of the upside potential of the stock in exchange for the call premium (cash flow) earned on those stocks.
Covered call options on a stock portfolio provide a partial hedge against declines in the price of the stocks based on how much call premium is earned. If the stock price declines, it will have to decline more than the value of the premium received for the investor to be in a total loss position. Clearly during a period of declining or flat stock prices, a covered call strategy will outperform those who are simply buying and holding the stocks.
During a period of rapidly rising stock prices, a covered call strategy would still deliver a positive return, but it could lag the return of a traditional buy and hold stock strategy because any gains beyond the strike price are capped.
In fact, statistics bear this out. During historical moderate bull markets, range-bound markets and bear markets, a covered call strategy tends to outperform its underlying stocks. The CBOE S&P 500 2 per cent Out of the Money BuyWrite Index, known as BXY, is an index that uses a hypothetical “buy-write” strategy where each stock in the S&P 500 has a one-month call option written at 2 per cent out of the money (2 per cent above its current price).
The past two years, from 0ct. 31, 2009 to Oct. 31, 2011, are a great illustration of the value of a covered call strategy, as the BXY index delivered a better return than S&P 500, 23.11 per cent versus a 20.18 per cent return, and more importantly did so with lower volatility. During the past year, from Oct. 31, 2010 to Oct. 31, 2011, a period of exceptional volatility, the BXY index had a standard deviation nearly 20 per cent lower than the S&P 500.
In fact, the higher the volatility, the more money is earned in options writing. A covered call strategy actually increases its cash flow generation during higher volatility. Typically you can expect the yield to increase during periods of heighted volatility.
The advent of covered call exchange traded funds, which offer pre-packaged covered call strategies within an ETF, has created a simple way for investors to access professional covered call strategies that were traditionally the domain of institutional investors. These ETFs hold a passive portfolio of stocks that give them the appropriate stock sector exposure and then run actively managed options strategies on those portfolios.
