Covered Call as an Income and Hedged-Equity Strategy

Covered call writing is a time-tested approach that can add income, dampen volatility and diversify both equity and fixed income core strategies. Adding a covered call strategy in a core satellite, multi-asset-class approach can be accomplished as:

  • A hedged equity strategy with an “income kicker” to enhance overall income production
  • A supplement to a core large-cap strategy (especially late in the market cycle when valuations are long-in-the-tooth and price action is volatile) as a means of boosting income and mitigating downside risk
  • A better-yielding alternative to a high yield bond allocation

We believe that investors are well-served by strongly considering the addition of an income-producing covered call strategy in virtually all market environments and multi-asset class strategies. Madison’s active call writing/active stock selection approach provides more opportunity for premium income and alpha from underlying security selection than common passive call writing.

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What is a Covered Call Strategy?

A covered call strategy owns shares of a publicly traded company, while selling (or writing) call options on the same assets. Call options give the buyer of the option the right to purchase the stock at a predetermined “strike price” within a set time frame (typically nine months or less). Selling call options produces income to the portfolio, which can be distributed or reinvested: known as a “buy/write” strategy, the income may act as a source of yield to the investor, or can be reinvested to help offset losses in a market decline.

Several peer-reviewed studies suggest that a covered call strategy performs at least in-line with the S&P 500 Index over longer periods of time, while realizing lower standard deviation of returns.(1) The return profile is appealing, but investors must be aware that the performance of covered call strategies differs with market environments.

The covered call strategy tends to underperform in steadily- or sharply-rising markets as the income generated by covered call writing is offset by the opportunity cost of having appreciating, underlying assets called away. Income generated by selling covered calls in this environment tends to constitute the bulk of returns (supplemented by limited capital gains on the underlying stocks).

Downside Protection

In sideways and down market environments, covered call writing tends to outperform due to the significant income generated from selling calls, as well as dividend income from the underlying stocks and any alpha generated by the security selections of an active manager. Of course, even with the downside protection provided by the call premium and dividends, there is a greater likelihood that the options will expire worthless (out of the money) in this environment, leaving the portfolio holding the stock along with the premium income. While a steep market decline, such as that experienced in 2008, can result in a negative total return in a covered portfolio, its performance should exceed that of its underlying assets by roughly the amount of the premiums (minus expenses). We would argue that the current environment of full valuations and market volatility is favorable for covered call writing strategies.

Covered Call's Income Advantage

A primary attraction of writing covered calls is immediate income; the premium can vary depending on the security involved, the price history of the stock and the market environment. A volatile stock will likely offer higher call premiums, and the overall premiums for calls will rise as overall market volatility rises. This pattern is popularly measured by the Chicago Board Options Exchange Market Volatility Index (“VIX”), which tracks the implied volatility of S&P 500 index options. The premium income from writing these calls can provide an alternate method for generating yield.

A report published in January 2012 gives a sense of the income potential of covered call writing, showing 1.8% historic monthly yield of the BXM between June 30, 1986 and December 31, 2011.(2) Option income is usually taxed as short-term gains, making the strategy best suited for tax-deferred and tax-exempt assets, but, depending on the length of the option, income may also be taxed as long-term gain.

Potential for Positive Return in a Flat Market

A covered call strategy can be a powerful alternative strategy for performance in a flat market. Writing calls with a strike price out-of-the-money (e.g. $55 on a $50 stock) allows room for capital appreciation, while earning the call premium. Out-of-the-money calls have a strike price higher than the current market price of the underlying security. Across a diversified portfolio of stocks on which call options are written, the premium income can boost returns above a stock-only portfolio in a year in which the traditional stock indices are up nominally. In the past, there have been long periods of flat returns in the equity market: these are the periods in which a covered call allocation can be a significant driver of value-added returns. The least conducive environment for a covered call strategy is a steeply advancing market, since much of the gain on underlying securities will be truncated by the securities getting called away at strike prices lower than the advancing market price.

An Analytical Review of a Covered Call Strategy

A study by Goldman Sachs in January 2012(2) reviewed 16 years of covered call trades (1996-2011) and concluded, “overwriting added to returns and lowered the risk of diversified portfolios.” The extent of the advantage was quantified as 3.6% annually, with a reduction of standard deviation of monthly returns by 20%. These results were predicated on selling 10% out-of-the-money, one-month covered calls on S&P 500 stocks with liquid options. In addition, the study found better results from writing calls on large-cap over small-cap companies, while there was no significant difference between value and growth stocks. The results were also based on writing covered calls on a large number of stocks, with a specific (10%) out-of-the-money prescription, using one-month options. While this methodology differs from Madison’s covered call writing strategy, it lends credence to our belief that a carefully managed covered call strategy has the potential to produce attractive returns, reduce risk and provide meaningful additional income.

Madison’s Covered Call Management

Active Stock Selection – Madison starts with a growth-at-a-reasonable-price (GARP) approach to build the underlying covered call equity portfolio. The process seeks to select high-quality companies, which have solid balance sheets, excellent profitability, strong management and elicit confidence in continued profitability. We seek to purchase such companies when their valuations are reasonable, and when we see the available option premiums for the stock as attractive. We focus on larger companies (market caps of $3 billion or more) that have a history of excellent return on capital, strong long-term growth rates and positive cash generation. Historically, the majority of our investments have been focused on the Financial, Technology, Consumer, Health Care, Energy and Industrial sectors.

Our active stock selection process, which includes rigorous fundamental analysis of all portfolio candidates, results in a high-conviction portfolio of 40-70 stocks. We seek to avoid over-priced and speculative issues through our valuation discipline. We expect the stock component of our portfolio to show lower volatility and better downside protection than the market in general.

Active Call Writing – We purchase individual stock options, rather than index options, because we believe individual stock options can offer higher premiums. Typically we write out-of-the-money calls which allow for the potential for upside participation if the underlying stock price advances. When selecting options, we look at the outlook for the underlying stock, the outlook for the overall market, the implied volatility history of the stock and the absolute and annualized total return potential for each stock/option combination. We often have multiple calls written for the same stock in the portfolio, giving us a range of strike prices and option expiration dates.

Why Madison Covered Call?

Madison has been a leader in covered call management since 2004: the Madison Covered Call and Strategic Equity Fund (MCN) was the first closed-end covered call strategy fund traded on the New York Stock Exchange. The firm also manages the Madison Strategic Sector Premium Fund (MSP), another closed-end fund traded on the New York Stock Exchange, and the Madison Covered Call and Equity Income Fund, a proprietary, open-end mutual fund. Madison’s strategy of active stock and option management differentiates its portfolios from the more common passive strategies, and provides an opportunity to manage risk while exploiting the higher premiums available for individual stocks. The lead portfolio manager, Ray DiBernardo, CFA, has been working on the strategy since its inception in 2004, and the team together brings nearly 60 years of investment experience to their covered call clients.