Covered Calls Trading Strategy

Covered Calls Trading Strategy – (QQQ & SPY, Income – Backtests Analysis)

Covered calls trading strategy looks 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?

A covered call is a poor investment strategy, but it also depends on your aims. 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.

This article will analyze the purpose of using Covered Calls Trading Strategy, and we use examples for both S&P 500 (SPY) and NASDAQ 100 (QQQ). We will see under what market conditions it is favorable, for which type of market participant this strategy is suitable, and its performance. Main takeaways:

  • Covered Calls Trading Strategy are not suitable for a Buy & Hold portfolio (and most likely underperforming in the long run).
  • Covered Calls are a strategy for generating income.
  • Covered Calls Trading Strategy premiums are taxable income.
  • They benefit from a stable or slightly bullish market.
  • This instrument is not suitable for every investor profile.
  • They have potential when combined with other option strategies, but you need to know what you are doing.
  • Covered calls are often part of a wheel trading strategy

However, in general, we believe this is an inferior trading strategy. First, let’s explain what a covered call is:

What is a covered call Trading Strategy?

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).

What is the definition of an option?

An option is a financial contract that grants the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and on a specific date.

The underlying asset can be stocks, bonds, currencies, commodities, or other financial instruments. The seller of the option, also known as the issuer or writer, is obligated to sell or buy the underlying asset if the buyer decides to exercise the option.

A “Covered Call” is an options strategy in which an investor owns the underlying asset (usually stocks) and sells a corresponding call option for that asset. This strategy is considered “covered” because the investor owns the underlying asset as protection against the obligation to deliver the asset if the option buyer decides to exercise it.

Covered call income strategy example

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).

Call writing is a negatively skewed trading strategy. You have many small winners because you cap the upside, and occasionally some big losers. Nassim Taleb believes this is a crackpot strategy.

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

Many strategists claim covered calls are a good strategy because they increase the Sharpe Ratio, profit factor, or other system performance metrics.

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 – so called negatively skewed distributions.

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, perhaps only for this looking for a covered call income strategy.

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.

Why covered calls trading strategies are risky?

There are some important points to consider with the Covered Call strategy. Let’s remember that options are a leveraged instrument, with 100 shares of the underlying asset behind each contract.

Suppose the underlying asset’s price exceeds the exercise price and the option buyer decides to exercise it. In that case, the investor is obligated to sell the asset at the agreed-upon price, which (of course) limits the potential gains if the asset appreciates significantly. But even more importantly, there is the risk of asset depreciation in a bearish market environment, which limits profits from premiums every time a new contract is issued.

Covered calls investment strategy 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:

Trading Rules

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This is the performance of this strategy compared to S&P 500 (source is Google):

Are Covered Calls A Good Strategy

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:

Covered Call income strategy

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) example

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 writes monthly at the money calls. This is the performance since BXMX’ inception in 2005:

Covered calls investment strategy  backtest

10 000 is invested in 2005 and compounded, meaning all dividends from BXMX is invested back into the ETF.

What do we learn from this exercise and backtest? In the long-term, a covered call trading strategy is likely to underperform a buy-and-hold strategy because the upside is capped, but the strategy only partially limits the downside.

Let’s make a specific covered call example for the ETF with the ticker code QQQ:

Covered Call income strategy examples in NASDAQ 100 – QQQ

As the article’s title suggests, we will use QQQ as a tool to evaluate a Covered Calls strategy and assess its performance. QQQ tracks Nasdaq 100 and started trading in the 1990s.

For our first example, we will issue a Covered Call with an at-the-money strike price and a 30-day expiration. Let’s remember throughout that we are SELLERS of a Call option.

  • QQQ Current Price: $337
  • QQQ purchase Price: $337
  • Number of shares: 100
  • Cost: $33700
  • Issuers: 1 contract (write)
  • Strike Price: $337
  • Expiration: 30 days
  • Option price: $7.48 (using Mid as fair price)
  • Income from option sale: $748

Estimated returns:

  • Entry credit: $748 net credit
  • Maximum risk: $32.958,00 (QQQ at $0,00)
  • Maximum return: $748,00 (QQQ at $337,00)
  • Max return on risk: 2.27% at expiration (25.1% annualized)
  • Breakeven at expiry: $329,52

Let’s do another QQQ example playing with the contract duration, this time for 6 months. Let’s remember that the strike of the option is at the money, meaning a price of 337 or the closest possible.

Estimated returns:

  • Entry credit: $2512,00 net credit
  • Maximum risk: $31.188,00 (QQQ at $0,00)
  • Maximum return: $2312,00 (QQQ at $335,00)
  • Max return on risk: 7.41% (15% annualized)
  • Breakeven at expiry: $311,88

As a final QQQ example, we will look for a strike price 5% above the current price of QQQ (out of the money) and a duration of six months.

Estimated returns:

  • Entry credit: $1623,00 net credit
  • Maximum risk: $32.077,00 (QQQ at $0,00)
  • Maximum return: $2923,00 (QQQ at $350,00)
  • Max return on risk: 9.11% (18.5% annualized)
  • Breakeven at expiry: $320,77

As we can see, the annualized return greatly exceeds the current annual performance of QQQ, which is around 9% at present.

In the event that the price surpasses the strike and becomes in the money, the shares are sold at the agreed-upon price, and our profit will be the contract premium, capital gains, and the asset’s dividends.

If, on the other hand, the price of QQQ does not exceed the strike at the contract’s expiration, we can issue a new Covered Call with the possibility of collecting more premiums and averaging down the purchase price: Rinse and repeat as long as we don’t get called away.

Annualized returns are always theoretical because they estimate an equal risk-return relationship over time.

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:

Covered calls example

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, believing 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.

Is time my friend or enemy when doing a Covered Calls trading strategy? The role of theta

Let’s remember that in the Covered Calls trading strategy, time is our friend because we write premiums.

The temporal decay of the contract value in options refers to the decrease in the value of an option as the expiration date approaches. Options have a predefined expiration date, after which they lose their value.

As time progresses and the expiration date approaches, the probability of the option ending up in the money (meaning it has value) decreases. Temporal decay is represented by “theta,” one of the Greek measures used to quantify how the value of an option changes in relation to the passage of time. Theta is a negative measure, which means that the value of an option decreases as time passes, especially when the expiration date approaches.

Why do investors and traders sell covered calls?

The idea behind this trading strategy is to generate additional income aggressively through the sale of the call option while maintaining ownership of the underlying asset. If the price of the underlying asset does not reach or exceed the exercise price before the expiration date, the investor can retain the underlying asset and keep the premium received from the sale of the option. As we said before, rinse and repeat.

Imagine that you are an insurer, and your clients want coverage or insurance to protect themselves, in this case, if the market crashes or sharply rises. However, you sell them the option to be covered for events that have a certain probability of occurrence in exchange for a premium. This is where the theoretical valuation of premiums comes in. Selling uncovered calls or exercising options in search of large premiums without analyzing the probabilities is a sure path to ruin.

Adopting Covered Calls as a investment strategy will depend on your objectives, risk tolerance, and your perspective on the behavior of the underlying asset. For a trader who generally does not seek unnecessary exposure to an asset and controls risk by limiting it to the duration of their trades when entering and exiting the market, Covered Calls are not an efficient instrument. For an investor who allocates a portion of their portfolio to aggressively generate income, a Covered Call strategy is perfect, benefiting from compound interest and dividends from the underlying asset.

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 for 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.

Covered calls stocks

Wealth managers determine, based on their clients’ risk profiles and time goals, which capital within an investment portfolio is appropriate for these types of strategies that aim to generate income or yield with a certain regularity. To achieve this, they allocate assets and capital within the investment portfolio for this purpose.

In a conservative profile, where a client is seeking retirement but desires monthly income to cover routine expenses (seeking income higher than what treasuries, corporate bonds, or even high yield investments can provide), the wealth manager may allocate a portion of the capital to assets that the client feels comfortable owning even if the asset price falls. Historically, these assets have preserved the value of the capital and have liquidity in the options market.

In a conservative profile for a young client, who cannot tolerate significant drawdowns in their investments but would like some exposure to higher-risk assets (a mix of fixed income and equity), the Covered Calls strategy can be used to generate income that can then be allocated to purchasing positions in higher-risk assets without touching the principal capital or dismantling positions in the main portfolio.

To be a writer of Covered Calls implies having a long position in stocks and selling call options on those stocks. This strategy may be suitable for stocks that meet certain criteria:

  1. Stable (sideways) or slightly bullish movements: The covered calls strategy benefits from a stable or slightly bullish market, as the objective is to generate additional income through the premium of the sold option. Therefore, it is advisable to select stocks that are expected to have a stable or bullish performance in the short term.
  1. Stocks with moderate volatility: The volatility of stock prices is an important factor to consider when implementing a covered call strategy. Option premiums may be attractive if the volatility is too high, but the risk of price fluctuations is greater. Therefore, it is advisable to choose stocks with moderate volatility.
  1. Stocks with liquid options: It is important for the selected stocks to have liquid options available in the market. Liquidity refers to the ease with which options can be bought and sold without significantly affecting their price. High liquidity is important to obtain fair prices and avoid execution problems in trades. Equity market options like QQQ and SPY have very high daily liquidity.

For these reasons, ETFs that track indices such as QQQ and SPY are attractive instruments for the Covered Calls strategy, as their implicit diversification meets the requirements for this instrument. Let’s remember that in an investment portfolio, these indices can simultaneously occupy two different positions, that is, as buy-and-hold assets and in another percentage for options strategies like Covered Calls.

Are Covered Calls Better than Buy and Hold?

As we saw before, we cannot compare Buy and Hold with Covered Calls because they have different purposes (income vs. capital gains) with very different time horizons within an investment portfolio. You are writing covered calls for income, thus it’s an income strategy.

However, by utilizing a Covered Calls income strategy, you can expect to underperform compared to Buy&Hold for the long term.

Here’s an example of the impact on a portfolio compared to traditional fixed income:

Are Covered Calls better than Buy and Hold?

Are covered calls worth it?

Covered Calls are not an instrument of a Buy & Hold portfolio; they are used in specific income-generation strategies that are more aggressive than traditional fixed income with assets allocated for that purpose. This strategy is particularly powerful when combined with other strategies such as Covered Money Puts.

FAQ covered calls

Based on the number of e-mails we get we decided to make a FAQ to better address any issues about the covered call strategy:

How does covered call work?

Covered calls mean you buy the stock and issue/sell calls on the shares. It’s a simple strategy, but difficult to be really successful at.

Can you lose money covered calls?

Indeed, you just have a slightly different profit and loss profile compared to owning the stock.

Is covered call a good trading strategy?

We believe it’s a poor investment strategy because you limit the upside and only reduce the downside. It works in flat and sideways market, but rarely in a strong bull market.

What is a covered call example?

We have given you an example of a covered call further up in this article. Click here for a covered call example.

What are the best stocks for covered calls?

That is hard to tell because there is no free lunch in the markets. You’d want to issue covered calls on slow and boring stocks, but that also means you’d get less in option premiums for the options you sell. All option premiums are based on future expectations and the markets are mostly random.

Are there covered calls ETFs?

Yes, BXMX, for example. History shows that they have underperformed the market.

Do you lose money rolling a covered call?

Yes, because yo need to pay commissions and slippage, and it also may include taxes.

Should you sell covered calls?

We believe it’s a poor investment strategy because you limit the upside and only partially limit the downside (as detailed in this article).

What is better than covered calls?

We believe it’s better to be a long-term owner of stocks and businesses, or do trading (or best, to both!).

What’s a poor man’s covered call?

A poor man’s covered call is a strategy that involves less capital required. It’s not a covered call in the real sense, but an structured covered call by using options (diagonal debit spread).

What happens if my covered call is in the money?

If your covered call is in the money it means you might get called away and have to sell your shares. Thus, you might have to pay taxes on the profits (if you have profits).

Is it better to sell weekly or monthly covered calls?

It all depends, you need to backtest your strategy. As said earlier in the article, there is no free lunch in the markets and flutuations are mostly random.

Do you get dividends if you sell covered calls?

Yes, you do get the dividends because you still own the stock.

Are covered calls a good trading strategy? Conclusion

At the end of the day, only you can judge whether this is a suitable trading 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 investment strategy, be in our opinion, it’s inferior, but this is a personal preference.

This is the reason: 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.

 

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