Last Updated on September 19, 2022 by Quantified Trading
Covered calls look tempting when interest rates and dividend yields are down because many investors and traders look for additional ways to generate “income”. Many pundits promise both good returns and “income” if you issue call options on your positions – so-called covered calls. Can you make money on covered calls? Are covered calls worth it? We look at covered calls backtest and empirical evidence.
Are covered calls a good strategy? Writing a covered call means you limit the upside drastically and only partially limit the downside. A covered call is a negatively skewed trading strategy, and thus we believe this is a poor trading and investment strategy.
Let’s go on the explain why we believe this is an inferior trading strategy. First, let’s explain what a covered call is:
What is a covered call?
You might be a beginner, and hence we start by explaining that a covered call is when you own the underlying instrument, most likely a stock, and then you issue calls on the same amount of stocks you own (or parts of your ownership). Let’s make an example of a covered call:
Let’s assume you own 100 shares in Microsft (MSFT). It’s trading at 300 and you want to issue calls three months into the future with a strike price at 320. To calculate the price of an option is a bit complicated and not the scope of this article, but let’s say you receive 10 USD per share, in total 1 000 USD. In practice, what does this mean?
It means that the buyer of the option has the right (but not an obligation) to buy the shares at 320 per share and you are obligated to sell at that price. If it’s an “European” call it can only be exercised at a specific date (the expiry date), while an “American” call can be exercised any time before the expiration date.
If the price rises to 350, for example, you are forced to sell your shares for 320 per share if the buyer exercises (of course he will, he can buy at 320 and sell at 350 in the market for a nice profit). If the share price of MSFT never goes above 320 or expires lower, the option premium is yours and you can rinse and repeat.
This is a covered call: you are buying the stock and selling the calls. Put short, you sell calls on the stocks you own to get “income”. When you sell options and you own the underlying stocks, you get this income because you have security in the form of owning the stocks. Nevertheless, we believe it’s a misnomer to call this “income” because it’s basically a capital gain, and that is not in any way “income”.
What is the tradeoff with covered calls?
When you sell covered calls you cap your upside potential to the strike price plus the option premium received, while you lower your downside risk partially (because you receive a premium).
Essentially, a covered-call/issuer investor and trader is trading the upside potential of the equity investment for an upfront fee and reduced exposure to downside risk (by the size of the call premium).
An even worse strategy is selling naked calls, ie. that is if you don’t own the underlying stock(s). By selling naked calls, you have potentially unlimited risk because the stock can theoretically rise unlimited. Just look at what happened to Gamestop in 2020! If you issue calls at 25 per share, the losses are devastating if the share price goes to 300 like it did in Gamestop. It’s like picking nickels in front of a steamroller.
(Please also read our take on selling puts: Is selling puts a good strategy?)
Why write covered calls?
If you want to guarantee an inferior strategy, do covered calls.
– Blair Hull
Typically, most risk metrics look at volatility, but volatility is only one part of the puzzle. As we mentioned above, the skewness of the profit distributions might be on the left side.
Even though you are covered by owning the underlying shares, you cap the upside up to the strike plus the option premium received, while the downside risk is still 100% minus the received premium. There is no free lunch in financial markets! This is why we believe this is a strategy that doesn’t make much sense.
Covered call do increase the Sharpe Ratio, but it produces negative skewness of returns. For example, if you compare to buy and hold, the covered call strategy most likely is more negatively skewed than simply buying and holding. You simply can’t have a good right fat tail with a covered call as you can with buy and hold.
Covered calls backtest – empirical evidence
Let’s go from theory to practice and look at some facts about the performance of covered calls as an investment strategy:
Chicago Board of Trade makes an index that assumes the following:
- Every third Friday of the month a call option in the S&P 500 is issued.
- At the same time a hypothetical share of S&P 500 is bought.
- The strike price is at the money (meaning the strike price is the same as the current price of S&P 500).
- Rinse and repeat 12 times per year. Option premiums and dividends are reinvested and compounded.
This is the performance of this strategy compared to S&P 500 (source is Google):
As you can see, over the last five years the covered call strategy (blue line) has massively underperformed the benchmark. This is perhaps to be expected because of the spectacular positive performance of the stock market. In a rising market, there is no way such a strategy of writing at the money calls will beat the market because of the capped upside.
However, look at what happened during the Covid-19 mess in March and April 2020: the blue line performs better than the S&P 500 because of the received premiums. Thus, in a falling or slowly rising market, a covered call strategy can be reasonably effective. Also, keep in mind that during panics the price of options increases due to increased implied volatility. Thus, the options premiums you receive increase – perhaps significantly. This happened in March 2020.
If we zoom out and look at the longer performance, it looks different:
2000-2003 was a bear market, something we wrote about in anatomy of a bear market, and clearly the covered call writing was very efficient. The buy-write strategy had a clear lead into 2010, but the roaring bull market caught up in the end.
Covered call ETF (BXMX)
Now, the CBOE covered call index is what it is – a theoretical index. Let’s look at a proxy for a covered call backtest. We are fortunate enough to have the opportunity to compare performance in practice by looking at ETFs.
For example, Nuveen has an ETF called S&P 500 Buy-Write Income Fund (BXMX). This is what Nuveen writes on their homepages:
The Fund seeks attractive total return with less volatility than the S&P 500 Index by investing in an equity portfolio that seeks to substantially replicate the price movements of the S&P 500 Index and by selling index call options covering approximately 100% of the Fund’s equity portfolio value with a goal of enhancing the portfolio’s risk-adjusted returns.
The fund holds 250 of the 500 stocks in the index and it writes at the money calls monthly. This is the performance since BXMX’ inception in 2005:
What do we learn from this exercise and backtest? In the long-term, a covered call strategy is likely to underperform a buy-and-hold strategy because the upside is capped, but the strategy only partially limits the downside.
What difference does the strike price play when writing covered calls?
We have used a strike price that is at the money at the time of issuance.
If we change the assumptions a bit and use a strike that is out of the money, meaning we can utilize more of the upside and at the same time have less downside protection (because of smaller received premium), the risk and reward change: we tilt the skewness a bit to the right side.
It turns out there is an index that seems to replicate covered calls that are out of the money:
The yellow line is the theoretical Buy Write Index (BPY) that issues calls at 2% out of the money. If the S&P 500 is trading at 4 000, the calls have a strike price that is 2% higher, ie. at 4 080. The upper line is S&P 500, and the lower blue line is at the money covered calls.
As expected, the index with the higher strike price performs a little better because you get a longer runway on the upside.
Covered calls mean you get called away
We dabbled a little by writing calls on our positions a few years ago. For example, a few years back we had shares in Intel (INTC) and issued deep out of the money calls with a strike at 34 with expiration a few months into the future in the belief that an exercise of the options looked unlikely.
But Intel surprised and had a good earnings report. The result was inevitable: the share price increased substantially and we were forced to sell our shares at 34 only to see the price rise to over 40 and later to 45.
Hence, you can only write calls on stocks you are happy to depart with the stock.
Which stocks are best for covered calls?
You might argue that the best stocks for covered calls are those that move sideways. That is, of course, correct, but normally that is already discounted in the option premium you receive. Thus, the best stocks for covered calls are hard to determine. It’s all about volatility and expected future share price movement.
If you want to write covered calls the “market” you can do that on the ETF with the ticker code SPY. SPY is the oldest ETF around and started trading in 1993 and tracks the S&P 500.
Are covered calls a good strategy? Conclusion
At the end of the day, only you can judge whether this is a suitable strategy or not: Are covered calls a good strategy? In finance, beauty is in the eye of the beholder. But be aware of the negative skewness of a covered call strategy. We have tried covered calls, and we will not do it again. Personally, we look at covered calls as an unsuitable trading and investment strategy. It’s not a bad strategy, be in our opinion, it’s inferior.
Why limit the upside for a tiny downside protection? Not to mention that you are also liable to taxes on the premiums you receive and potentially capital gains taxes if you are forced to sell your underlying shares.