The following is an excerpt from our recent white paper, “Enhanced Income from Equity Options: A Guide to Covered Call Strategies.” The full paper offers a comprehensive overview of how covered calls work, their benefits and risks, how they perform in varying markets, and more.
What is a Covered Call Strategy?
Call options grant the buyer the right to purchase a stock at a specified price. Conversely, put options grant the buyer the right to sell a stock at a specified price. Both are used to generate income or hedge risk in a portfolio. A covered call strategy owns underlying assets, such as shares of a publicly traded company, while selling (or writing) call options on the same assets. Selling call options produces a stream of cash flow for the portfolio. This income can act as a source of yield for the investor or be reinvested to help offset losses in a market decline. Adding to the appeal for income-seeking investors is the possibility of dividends and potential capital gains generated from portfolio activity, distributed regularly.
It is important to note that the writer of a covered call option forgoes, during the option’s life, the opportunity to profit from increases in the market value of the security covering the call option above the sum of the premium and the strike price of the call.
From a risk and return perspective, covered call strategies tend to perform in line with the S&P 500 during steadily up, declining, or flat markets and lag when the market rises rapidly. All with less volatility, as measured by standard deviation. Over long periods of time and spanning all types of markets, covered call strategies offer a balance of market participation, risk mitigation, and income generation.
Covered call strategies in different market environments
The benefits of a covered call strategy are evident in all types of markets, some market environments more than others. This is why many equity investors seeking income allocate a portion of their portfolio here, while others seeking growth will carve out a portion of their more risky equity holdings to balance out their equity risk. This section explains how covered call strategies have performed in different market scenarios and why.
Down Markets
Covered call writing has tended to outperform against the broader equity market in down-market environments due to the income generated from selling call options. The portfolio continues to hold the underlying stocks when prices go down, but call premiums received help offset the falling prices and can potentially be reinvested in the same securities at a lower price point or another opportunity. An active manager in this environment can also benefit from security selection, where the portfolio can be managed to reduce risk and pursue excess returns over the market (alpha). In steep down market environments, such as in 2008, the result from a covered call strategy can be a negative total return.
Flat Markets
In flat markets, a covered call strategy can be a powerful alternative for both capital appreciation and income. Writing calls with a strike price out-of-the-money (ex: $55 on a $50 stock) allows room for capital appreciation while earning a call premium. As volatility increases, the value of the call premium also increases, giving the portfolio the potential for even more income.
Up Markets
A covered call strategy can still be effective when markets are up, as long as prices aren’t increasing so quickly that call options are exercised. Out-of-the-money calls will keep the premium income and capital appreciation as long as the stock price does not exceed the strike price. The least conducive environment is a steeply advancing market since much of the gain of the underlying holdings is truncated by the securities getting called away at prices below the current market.
