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Financial Industry Insights from Advisors Asset Management
On January 17, 2023
AAM Viewpoints — Low Returns and High Volatility? Time to Consider Covered Calls?
Introduction
The Options Industry Council (OIC), which educates investors and financial professionals about the potential benefits and risks of exchange-traded equity options, offers the following Covered Call description and motivation:
“This strategy consists of writing a call that is covered by an equivalent long stock position. An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional downside risk. The premium received adds to the investor's bottom line. It offers a small downside 'cushion' in the event the stock slides downward and could boost returns on the upside.”
The potential benefit is premium income generated. Of course, these benefits come at a cost. When selling a call option, there is a chance the underlying stock moves above the strike price and gets called away, and the investor could forfeit any gains beyond the strike price.
One cost/benefit breakdown would include:
Cost: limited or capped upside potentialPotential Benefit: premium income
Applications
We typically see two applications for Covered Call strategies:
Scenario Analysis
Proof of Concept
The Chicago Board Options Exchange S&P 500 BuyWrite Index (BXM) is a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index (“buy-write” is another term for covered call). In 2022, the total return of the BXM was -11.37%, outperforming the S&P 500 Index total return of -18.13% by 676 basis points. Note the BXM and the S&P 500 are the same basket of stocks, the difference in returns is the incremental income generated by BXM by selling or writing call options on the index.
A Covered Call Market
2022 was obviously a very challenging year for the equity markets with a max drawdown of 25% for the S&P 500, pushing the benchmark into bear market territory. Volatility was extremely elevated with a whopping 87% of S&P 500 trading days in 2022 trading in a +/- 1% daily range.
Source: Strategas | Past performance is not indicative of future results.
The December survey shows the consensus price target for the S&P 500 at year-end 2023 is 4,078. This would represent a modest 3% gain from current levels as of this writing (1/11/23). Additionally, Strategas points out in the chart above that years or periods of elevated volatility tend to happen in bunches, indicating the volatility we experienced in 2022 could potentially carry over into 2023.
Low returns coupled with high volatility are tailor-made for Covered Call strategies as the potential benefit of premium income to provide downside cushion or supplement total returns greatly outweighs the cost of capped or limited upside potential, in our opinion, setting up 2023 as an ideal environment to consider Covered Call strategies within equity allocations.
CRN: 2023-0109-10558 R
Risks associated with these strategies can include an increase in rates, a change in the actual or perceived volatility of the stock market and/or the common stocks subject to the option, a change in the dividend rate of the stock subject to the option, the remaining time to expiration, the adverse effects on the value of the options if the market becomes smaller or less liquid, or if the issuers or industries represented are the subject of legislative initiatives or litigation, and the limitations and various risks of options writing.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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