Covered call writing: too good to be true or… an overlooked gem
- Posted by Richard Croft on October 23rd, 2007 filed in Options Market
An interesting question recently about the risks associated with covered call writing. The writer’s strategy was to write at-the-money calls against the iShares CDN S&P TSX 60 Fund (symbol XIU). Once he has confirmed that he has bought the iShares, he sells the at-the-money calls. By doing so, he is able to define a profit range, exercised or not. And more importantly, as he says, “sleep soundly.”
The reader feel good, sleeps soundly. So where’s the catch?
Interestingly the strategy being employed is the same strategy used in the MX Covered Call Writers Index. With more than ten years of index history, we can say that the risk – defined as volatility - is less than the risk associated with a buy and hold strategy using the iShares. We can also say that since 1993, covered call writing has produced returns equal to the buy and hold approach.
Less risk than buy and hold. Returns equal to buy and hold. In the institutional market the combination of less risk, same return, translates into positive alpha. In much the same way as do higher returns with the same risk. In either case, positive alpha is generated through positive risk adjusted returns… the holy grail of fund managers.
Too good to be true? Well that might be a stretch. The real risk with covered call writing is the risk of losing a stock and missing sizeable upside gains. Which happens on occasion. But longer term, covered call writers know that markets spend most of the time in a trading range.
Even when the markets are moving, option premiums tend to expand which adds to the performance of the covered call writing strategy. In fact, the Mx Covered Call Writers Index has kept pace with the iShares performance during some very strong share price performance in the 1990s. Same today, despite a substantial updraft in Canadian stock prices supported by the energy sector.
And here is the real advantage. Did you know that XIU closed at $81.40 when the September options expired. One month later, at the October 19th, 2007 expiration, XIU closed at $81.39. The market gyrated up and down in October, but ended where it began. Buying and holding gained nothing. The covered call writer not only could “sleep at night” but collected a premium in the meantime.
Perhaps it is not about being too good to be true. Let’s just say that covered call writing is an overlooked gem in the financial services industry.
November 1st, 2007 at 1:57 pm
Richard:
Thank you for sharing your knowledge on BNN and this website. My question is “what does it mean when one is obliged to pay the dividend on early assignment of covered calls?” I was following a strategy on CBOE website training centre. The details are below.
Regards,
Ming
CBOE EXAMPLE.
Above the upper strike: No Position
Observe the following example:
Buy XYZ Stock @ 50
Buy 1 XYZ March 50 call @ 3
Sell 2 XYZ March 55 calls @ (1.50)
If the stock price is above 55 on expiration day, the 50 call will be exercised and the 55 calls will be assigned. All 200 shares will be sold upon assignment. There is a possibility of early assignment on the 55 calls which may result in an obligation to pay a dividend.
October 30th, 2007 at 2:08 pm
Derek,
Here is a link our informational page on RSS feeds: http://www.m-x.ca/publi_rss_en.php.
Do you have an RSS reader/agregator?
MJ
October 30th, 2007 at 1:42 pm
Hello Marie-Josée Laramée,
You replied to a comment from me on Oct 4th regarding the RSS feed. I have clicked on this many times at different locations and get just a jumbled up mess to read?
I have looked at and subscribed to other sites when a new post comes out it is either emailed or a notice is emailed to me. How do i subscribe to this? I notice that one part requires a login which i don’t have.
Am i missing something with RSS technology?
DH
October 24th, 2007 at 8:20 pm
Richard, I agree with just about everything you have written on covered calls. But what do you think about writing calls on the banks–say BMO or C or BAC–with their great yields right now? Sure you get the dividends and the call premiums but, if the banks lead the way back up, you also give up upside in the next move upwards. What is your opinion on this? Kevin
October 24th, 2007 at 4:29 pm
Well Richard i would have to agree with you on this. What investor wouldn’t want reduced volatility with the same returns that larger gyrations include. Of course one might need to consider the time spent using this strategy and any fees.
I imagine the fees would be something like a typical MER if one shopped around and was writing on a quarterly basis? It’s really too bad an ETF doesn’t offer this type of strategy, but who know’s what the MER would be?
DH