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
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.
Learn more about PowerShares S&P 500 BuyWrite Portfolio.
1 Source: Bloomberg LP, August 20, 2015
Important information
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the underlying index. The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
There are additional risks involved in writing (selling) covered call options. The fund, by writing covered call options on the index, will give up the opportunity to benefit from potential increases in value of the index stocks above the exercise prices of the options, but will continue to bear the risk of declines in the value of the Index. The fund will be subject to capital gain taxes, ordinary income tax and other special tax considerations due to its writing covered call options strategy.
Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.
A basis point is one hundredth of a percentage point.
Long positions make money when an investment rises in price.
A call option is an option to buy assets at an agreed-upon price on or before a particular date.
An option premium is the income received by an investor who sells an option contract to another parts.
Volatility measures the amount of fluctuation in the price of a security or portfolio over time.
Standard deviation is a measure of the dispersion of a set of data from its mean.
A risk premium is the amount of return an asset generates above cash.
The CBOE S&P 500 BuyWrite IndexTM is a total return benchmark index that is designed to track the performance of a hypothetical “buy-write” strategy on the S&P 500® Index. The CBOE S&P 500 BuyWrite Index measures the total rate of return of an S&P 500 covered call strategy. This strategy consists of holding a long position indexed to the S&P 500 Index and selling a succession of covered call options, each with an exercise price at or above the prevailing price level of the S&P 500 Index. Dividends paid on the component stocks underlying the S&P 500 and the dollar value of option premiums received from written options are reinvested.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
This article was written by Jason Bloom, Director Commodities & Alternatives Product Strategy for PowerShares.