Investment Road Test: Covered Call Options

PORTFOLIO POINT: A carefully managed “Delta” covered call options strategy can work well in flat markets, protecting against share downturns and paying out on potential upside.

British angel investor Richard Farleigh, a panelist on the television program Dragon’s Den, was in Sydney last week offering a somber reflection of UK and euro prosperity and lauding the strong Australian economy.

On the topic of financial market misbehavior, Farleigh was heard to remind commentators that he had started his career – and fortune – as a derivatives trader at BT in the 1980s and 1990s. In the same breath, Farleigh was quick to point out that derivatives were used “in his day” to manage and reduce risk – not to increase it!

In light of his reminder, we’ll look today at a landmark research paper released earlier this month by the ASX, which validates the improvement in share returns that can be implemented by selling simple call options over blue- chip shares. This is a process known as “covered call” or “buy/write” investing.

The significance of the ASX research is that (using real market data for share and call options) it confirms that the covered call strategy added positive returns before, during and after the savage market hysteria of the global financial crisis. The ASX research assessed a number of different call option strategies, showing that outperformance of between 20% to 60% was able to be added to the returns of blue-chip shares over the period between 2006 and 2011.

So, for sceptical investors that may be avoiding the sharemarket because of fears of another meltdown, the ASX research is a pointer towards the real value that has been created using simple stock and call option investing:

We’ll get into the detail of the ASX research shortly, after a quick recap of the concept of options (and specifically, call options). In line with Farleigh’s comment about risk management, we can see call options all around us (if we know where to look).

Property developers use call options to accumulate residential blocks, to reduce their risk compared to buying blocks one at a time (and perhaps to find that one or two residents hold out on selling to them, leading to expensive holding costs while they wait to convince the resident or their successors to sell). Institutions and traders buy call options to keep exposure to stocks and markets, in case they rise in value. Often when markets are volatile with potential for both up and downside movements, buying a call option can be a lower-risk way to gain exposure versus buying physical stocks.

Call options are significantly cheaper than buying the underlying physical asset to which they relate – the call option cost (or “premium”) represents the time value of the opportunity to buy the asset which the option provides, as well as the price at which the asset can be purchased by exercising the call option. So in traditional option parlance the call option is the “right, but not the obligation, to buy an asset by paying a preset price, by a specified time.” The cost of the call option is the option premium, and the preset price at which the asset can be purchased (i.e., by exercising the call option) is known as the “exercise” or “strike” price.

The ASX research was conducted by one of Australia’s premier independent financial research bodies, the supercomputer heavyweight of SIRCA (itself a collaboration between a number of Australia’s top universities).

The research looked at the use of covered call strategies conducted over 30 of the top, blue-chip stocks traded on the ASX. The basic approach assessed by SIRCA used a simple strategy of selling ASX “exchange traded options” (“ETOs”) with a term or maturity date of one month, and with an exercise price which was 5% (or as close thereto as possible) above the share price at the time the call option was sold.

Because the strategy is based on the investor also holding the same number of stocks as it sells the call options over, the strategy is fully hedged, and hence is known as “covered call” writing. (This compares to not holding the same number of shares – or holding none at all – which is known as “naked” call selling).

In the case of covered call writing, the investor’s risks are:

• The share price falls (but because the investor will generate cash by selling the call options and receiving the option premium, the downside risk is less when covered calls are sold than it would be if the shares were held outright);
• The share price rises by more than the strike price of the call option (in which case the buyer of the call option will exercise it and be able to buy the share for a price which is less than the then prevailing market price).

So how did the process of selling call options over these blue-chip stocks actually perform over the last few years? As can be seen from the chart below, which maps the performance of six differently managed call option strategies, careful use of covered call writing has been able to add strong outperformance vs the shares themselves.

Click to enlarge

Source: ASX Limited, “An Encyclopedia of Buy-Write Returns (April 2005 to December 2012)”

Lets look at two of the call strategies which the paper analyses: the “basic” (shown in the red line in the chart) and the “delta” (shown in the gold line in the chart).

Each of these deal with some of the practical concerns which investors will experience when implementing a covered call approach. As you may be thinking, the problem in a rising market is that the sale of the call option will give the holder the opportunity to force you to sell your stock below the price at which it is trading when the option is exercised. For sure, that price will be higher than the price of the stock when the call initially was sold (so you will make a profit on the stock itself). But the sale price will mean that you have capped the upside on the stock – perhaps something to be avoided by active management of the call option position?

The simplest way to avoid losing stock when a call option is exercised (which leads to the stock being “called away”) is to buy back the call option position. That doesn’t mean that you have to locate the actual buyer of the call option that you earlier sold – ASX ETOs are fungible and traded via a central clearing house. (Note to Lehmans – why didn’t you set up a central clearing house to reduce couterparty risk?). So to close out a sold call option position you simply have to buy an equivalent position (e.g. the same strike and maturity call as you have previously sold). To prevent having to dip into your pocket to buy back (the now more expensive sold call option), it’s normal to sell another call option (with a higher strike price and/or a longer maturity date) to fund the transaction.

The difficulty arises in figuring out when (and at what price) you should consider buying back a call position when the underlying shares are gaining in value. In fact, the courts are littered with claims from retail investors against unscrupulous stockbrokers who have “churned” their clients’ portfolios when charged with the responsibility of managing covered call positions to avoid the investor being called away.

Enter the ASX research, which is massively helpful to investors because it actually considers the outcome of a number of different ways of managing the close out and resale of new call options. In fact, the “basic” strategy simply allows the call option to be exercised (if the share price has risen enough) or to lapse. Although letting the call option be exercised will mean that the position may underperform compared to simply holding the share itself (and not selling the call option), in the surveyed period there were sufficient periods where the shares didn’t rise through the call option strike price to validate the basic approach.

The “delta” strategy looks at hard coded rules to govern the overall position management. Using a simple option pricing calculator (these tools are available on the ASX website) to determine the “delta” of the sold call option, it is possible to set a trigger level to govern the close out of the sold call option. In the ASX research, the “delta” strategy triggered a buyback of the sold call option when its “delta” rose to the level of 0.85 during the option term.

Delta is a concept which measures the degree to which an option tracks the underlying share performance: A delta of 0 means that the option does not provide any exposure or correlation to movements in price of the underlying asset to which it relates; and a delta of 1 means that the option and asset prices move by the same amount.

So in the ASX survey, if a call option is sold with an exercise price 5% above the share price, the amount by which the call option price rises will initially not be the same as the price movements in the share. But if the share price rises and starts to approach the call option exercise price, the amount by which the call option price rises during the option term will increase – representing a rising delta for the option.

In the ASX research “delta” strategy, if the stock price rises sufficiently to cause the delta of the call option to rise to 0.85, the originally sold call option is bought back and another call option is sold to fund the buyback. In this scenario, the new sold call option also matures on the same date as the original call option, but the new call has an exercise price as close to 5% above the (then prevailing) share price as possible.

Full details of a range of other strategies are set out in the ASX research paper. The actual returns for each of the 30 stocks are set out in the paper. Interested investors can use the ASX paper as the basis for their own trading strategies – noting of course the general risks of sharemarket investing (although as noted above, consider covered call writing as a way of subsidising share investing).

ETOs are the most liquid and readily available options over ASX-listed shares – and they are backed by a strong central clearing house and the experience of the ASX options market (the second-oldest stock option market in the world).

A wide range of support materials is available via the ASX website – lending support for a DIY option investor. Beware of paying high brokerage to transact options – as this will erode overall returns.

As the ASX research shows, covered call writing works best when the market is flat and trends sideways. If you expect this to be the pattern for the sharemarket for a while, selling call options can be a great way to monetise “the will o’ the wisp” that we know as the equity risk premium.

For at its core, the benefit of the covered call approach when markets are flat is that selling the call option means you get paid for the prospect of selling upside on the share which ultimately may not be realised. And that is a great result in anyone’s language.

The score: Covered Call Options – 5 stars

1.0        Ease of understanding/transparency

1.0        Fees

1.0        Performance/durability/volatility/relevance of underlying asset

1.0        Regulatory profile/risks

1.0        Innovation

(The scorecard relates to the “delta” strategy in the ASX research paper)

Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides consulting and financial product services but does not receive any benefit in relation to the product reviewed.