INSIGHTS

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 potential
Potential Benefit: premium income

Applications

We typically see two applications for Covered Call strategies:

1. Covered Calls can be used strategically for income-focused portfolios to help meet income objectives.
2. Covered Calls can be used tactically for investors looking to outperform the broad equity markets based on their outlook. In an upward trending or bull market, we would expect Covered Calls to underperform as stock prices move above the strike price of the call options. However, in a range-bound or a downward trending market, we would expect Covered Call strategies to outperform as the premium income could provide some downside cushion.

Scenario Analysis

• BULL MARKET: An investor will likely underperform the market as they keep the option premium, but forfeit some or all of the upside.
• FLAT MARKET: The investor will likely outperform as the markets go nowhere, but the investor keeps the premium from selling the call option.
• BEAR MARKET: The investor will likely outperform as they keep the premium received from selling the call option, which offsets some of the stock’s decline.

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.