An Option for Choppy Markets | ETF Trends

It has been some time since the US equity market has favored a covered call strategy. Because covered calls limit an investor’s upside profit potential, strong bull markets are not the optimal environment for this strategy. Rather, a covered call strategy has the potential to work best in markets that are moving sideways or along a gentle slope up or down—much like the choppy, sideways equity market we have seen in the US throughout much of 2015.

I believe now is the time for investors to learn more about this strategy, and talk to their advisors about whether a covered call strategy is right for them.

What is a covered call?

A covered call strategy involves taking a long position in a stock and selling call options against that same stock. The purpose of this strategy is to maintain exposure to the long-term growth potential of a stock, while generating income from the option premium over the shorter term.

This type of strategy is easy for investors to access through exchange-traded funds (ETFs), such as the PowerShares S&P 500 BuyWrite Portfolio. This smart beta ETF makes use of a covered call subset known as a “buy write” strategy whereby the underlying index buys the stock and sells the options as part of the same transaction.

What has 2015 looked like for covered call strategies?

In bull markets, covered calls give away a portion of the market’s appreciation in return for the income generated by the option premium. However, recent equity markets have struggled to move higher as they digest declining global growth expectations — which could benefit covered call strategies. Year to date, the S&P 500 Index is up only 0.73%, including dividends1 — held in check by the headwinds of China’s recent currency devaluation, sputtering economic activity in emerging markets and Europe, and the effect of the strong dollar on US corporate earnings.

As such economic forces can be slow to change direction, I believe we may be facing several years in a low-growth world marked by declining equity market returns and ultra-low government bond yields.

How have covered calls performed recently?    

The charts below illustrate how the buy write strategy — illustrated by the CBOE S&P 500 BuyWrite Index — has performed in the recent bull market, and in the more recent sideways market. In the first chart, you can see that the S&P 500 Index has generated much stronger cumulative total returns starting from 2012. But when we focus in on the largely sideways market of 2015, the buy write index has generated higher cumulative total returns by owning — and writing call options against — the S&P 500 Index. Not only has the covered call index outperformed the S&P 500 Index by 281 basis points in 2015, but it has done so, by definition, with less volatility – exhibiting a standard deviation of 8.59% versus 12.05% for the S&P 500 Index.1

The buy write index has lagged the broader market in the recent bull market

Choppy, sideways trading trends have recently favored a buy write options strategy

choppy markets

What is the outlook for covered call strategies?

If such sideways conditions persist, we are likely to experience higher levels of equity volatility and higher sustained risk premiums. I believe this will make call-writing strategies more important than ever as an option for sourcing income and supplementing dwindling equity market returns. Remember, as equity market volatility increases, option risk premiums increase, which in turn can increase the amount of income call writers are able to generate.

If one expects the US equity market to continue along in the same choppy fashion — failing to break out strongly to the upside or downside, a covered call strategy could be especially attractive.