The markets have been wonderful over the past year and a half. Some may say even too wonderful. Currently we have low yields on bonds and stocks at all-time highs. As always, BDF’s Investment Committee scours the landscape for ways we can make long-term fundamental improvements to your portfolio. You often hear a lot about what does change, but sometimes not enough about what else we review. Against this backdrop, one strategy we recently reviewed is a ‘covered call writing’. Ultimately, the return profile and costs were hurdles that were too much to overcome for now, but below are some insights into what the strategy entails.
Call Options 101
You are probably thinking to yourself – what exactly is covered call writing? Jump aboard a quick class to Options 101! A call option is a contract that allows the purchaser the right, but not the obligation to buy a stock at a certain price and time. They work well when you believe a stock is heading higher. For example, let’s say you purchased a call option on stock XYZ with a strike price of $35. Currently, the stock is worth $25. If the stock traded higher to $50 and you exercised your call option, you would purchase XYZ at your $35 strike price rather than the market price of $50. A nice $15 profit.
Are you still with me? If so, take everything you just read and flip it on its head! In the case of call writing, instead of buying the option you become the seller. So, rather than the right to buy a stock, you must sell the stock to the buyer if they choose so. In our example above, if you sold that exact same call option you would be forced to sell stock XYZ at $35 rather than the market price of $50. Thus, you would lose out on potentially $15 of upside return.
However, an important facet of options is in order to buy these call options the buyer pays the seller, which in option parlance is a ‘premium.’ While it is an out of pocket expense for the buyer, it is income to the seller. To continue with our example above, let’s say the premium paid to the seller was $5. If, instead of increasing to $50, stock XYZ continued to trade at $25, the call option would expire worthless and the seller would keep the premium, in this case the $5 as income.
Receiving the option premium is the crux of the call writing strategy and a reason that investors utilize this in an investment portfolio. The premium is a source of income that can increase overall returns. The strategy can also help to reduce risk in the portfolio. If stocks were to depreciate in value, the call premium received would help to offset losses and create a positive income stream even in a down market.
Although there are benefits to the strategy, low premium levels and additional costs are challenging obstacles to overcome in today’s environment. Stock market volatility is one of the main drivers that affect premiums. Volatility has been at historic lows (see chart). This low volatility environment reduces the amount of premium you receive. Call writing strategies also add additional transaction, tax, and management costs. Given these added layers of cost and complexity, the reward is not enough to overcome these costs.
Call writing strategies offer many benefits that can seem beneficial to a portfolio. However, at present the obstacles have led us to pass for now. We will continue to analyze this opportunity and many others alongside the ever changing market landscape.