Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
Every few years, covered call writing captures the attention of investors and some money managers. We’re in one of those periods now.
There is some correlation between investor enthusiasm and market uncertainty. This makes sense, as covered call writing is, at its core, a hedging strategy that lowers volatility and downside risk.
Early in my career, in the early 1980s, I was tasked with managing a covered call writing program for a relatively small and forgotten trust and mortgage company. The program was remarkably successful given the volatility and option premiums that existed at the time. The question today is if this strategy is a good idea in our current world.
First, it is necessary to explain what covered call writing is and what it is not.
Simply stated, an investor owns stock or an index and sells a call against it. A call is a right to buy a stock at a specific price, commonly called the strike price, by a certain date. For example: Acme stock is trading at $20 today. A speculator can buy a call maturing Dec. 15 for $22 – 10 per cent above today’s price – for 75 cents. A holder of Acme in turn may sell the speculator calls and accrue 75 cents per share (for simplicity, let’s assume no trading costs). If the stock closes below $22 on Dec. 15, the call buyer’s options expire worthless. If the stock rises above $22, the stockholder will give up their shares to the call holder and will have a profit from the initial day of $2.75 – the difference between the strike price and market price plus the 75 cents for the call. That is 13.75 per cent in four months or more than 40 per cent annualized. If the stock soars to $30, the stockholder will forgo that rise, leaving $7.25 on the table. The call holder will make $6 – that is, $30 minus $22 minus the $2 initial cost. A 200-per-cent return over a few months is nice but happens infrequently. If the stock drops 10 per cent to $18, the investor will still have a loss but only of $1.25, or 6.25 per cent (the loss of $2 minus 75 cents).
One can plainly see the risks and return potential of the call buyer and covered call writer in this example. The speculator can make an enormous profit but will lose money most of the time. This is sort of like playing your favourite number at the roulette table in Vegas. You may get lucky but will not do well in the long run. In contrast, the covered call writer gives up some of his upside for immediate cash and somewhat mitigates some of the downside. This is why covered call writing is called a hedging strategy.
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Some call it an income strategy. In a way it is because the investor collects a premium. I eschew this and prefer to put the strategy in the alternative asset category, although it is a unique hybrid of the equity market. An investor can still lose money if the security falls. Ultimately, this is a volatility strategy. The call buyer is exposing themselves to volatility, while the writer is selling or hedging his volatility. Mathematically, there is little argument that covered call writing reduces volatility. Therefore, it follows that this strategy would underperform stocks in a rising market.
The S&P 500 enjoyed outsized returns of more than 10 per cent per year over Treasury bonds between the lows of the 2007-2008 financial crisis and the previous market peak in 2021. This, in my view, is completely unsustainable as long-term valuations – such as the Shiller P/E ratio – are at levels only seen in 2008, 2000 (the dot-com bubble), the late 1960s (the Great Inflation) and 1929 (the Great Depression). Now is probably a good time to consider covered call exchange-traded funds.
Option pricing is complex, and the strategy is best left up to professionals who employ quantitative analysts. The long-term performance of a covered call program is highly dependent on the expertise of the manager. Some practitioners will make the mistake of not paying attention to the individual security and will be seduced by high call prices. Although easier said than done, only stocks with positive outlooks should be in a portfolio. Pricing is crucial, as are chosen strike prices and expiration dates.
Covered call writing requires a high degree of emotional maturity and a rejection of greedy impulses. If the security rises, you should not have written the call, in retrospect. You made money, but not as much as you would have being long. If the security falls, then selling would have been better.
However, over the long run, the strategy does remarkably well in a period of sideways and lacklustre markets.
Covered call investors are literally selling volatility. Therefore it makes sense to gain exposure to programs that have ample volatility to sell. Although there are funds that concentrate on more stable sectors such as banks and high-dividend stocks, I think sectors with higher volatility are more optimal. The gold sector is certainly attractive, and the Horizon Gold Producer Equity Covered Call ETF (GLCC) would afford the investor exposure to the sector with less risk. Another attractive candidate is the Horizon Canadian Oil & Gas Equity Covered Call ETF (ENCC). The Bank of Montreal offers the BMO Covered Call Technology ETF (ZWT). Investors who desire exposure to this sector but want to dampen the rollercoaster ride inherent with these stocks should have a good look at this fund.
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