Covered-call strategy offers no free lunch

By Dan Hallett, CFA, CFP on July 24th, 2012

Extra-lean bond yields are prompting investors to reach for yield with corporate, high yield and emerging markets bonds.  Their appetite for stocks is meagre overall but investors still hunger for those that regularly spit out cash – sometimes using them as bond replacements.  As for investment funds, my keyboard is almost too tired to type out the phrase monthly income fund but their popularity is similarly driven by low rates.

A newer and more complex breed of income fund stands to disappoint investors yet again in my opinion.  Investors are snapping up exchange traded funds (ETFs) that use covered call-writing strategies.  The strategy isn’t new – covered call writing has been used by portfolio managers for more than two decades – but retail investor interest is growing.  Last month alone, covered-call ETFs grabbed 1/3 of the nearly $270 million in net new sales of Canadian-based ETFs (according to data from the Canadian ETF Association).  But I suspect that a fundamental misunderstanding of covered call strategies is behind the gap between investor expectations and reality.

The 90% myth

The strategy of selling or ‘writing’ option contracts is espoused by a growing number of investment professionals and non-pros alike.  Atop the list reasons supporting the strategy is the frequently-cited  statistic that “90% of options expire worthless” so – the argument goes – why not sell call options and pocket the premium?  But I remember seeing this same 90% statistic in my university textbooks (more than a few years ago).  I’ve seen and heard it so often – and the number never changes – that I figured it must be a myth.

The Chicago Board Options Exchange does state that 90% of options go unexercised, but highlights that just 30% to 35% of options expire worthless.  While option-writing is often held out as a can’t lose strategy, there are at least three solid fundamental arguments against it.

Asymmetric returns

Covered call writing involves buying stock and selling call options ‘against’ that stock position.  When you sell an option, you receive up front the premium paid by the buyer.  In doing so, you (as seller) also take on the obligation to sell shares of the underlying stock when and if the call option buyer chooses to exercise her options to buy the stock.  The buyer will exercise the options if the underlying stock price rises above the call option strike price.

You – the option seller or call writer – pocket the call premium up front.  If the price of the underlying stock collapses before the call expires, the call-buyer won’t exercise the option because the stock can be purchased more cheaply on the open market compared to the contract strike price.  In this case, you continue to own the stock – with all of its downside – but you also keep the premium income.

If the stock soars, the call-buyer will exercise to buy the stock at the (below-market) strike price, forcing you to sell the shares below the market price.  So, you get virtually all of the downside risk exposure while cutting off most of the upside potential.  And given the history (and expected future) of generally rising long-term prices, this strategy’s long-term potential is not attractive.

In other words, this strategy negatively skews the risk-return profile.  Covered call writing strategies are promoted as a source of income with less risk than owning stocks outright.  But adherents to this approach are giving away too much future upside in exchange for current income.  The amount of forgone upside may well dwarf the extra income over time.

Such a strategy can work for years and give the impression that it’s the new holy grail.  But I expect that the truth will be revealed over time as a series of strong bull periods causes the strategy to fall far behind simply owning the shares outright, without options.  That said, because covered call strategies often focus on more volatile stocks – because premium income correlates with volatility – these strategies sometimes suffer more damage during bear markets.  Fundamentally, the odds are against this strategy’s long-term success.

David vs. Goliath

Option trading is a quant game and big options traders – which often exclude traditional money managers – are in the best position to find pricing inefficiencies with their sophisticated computer models that can make decisions in a nanosecond.  Being on the other side of such trades is not a position I’d want to be in – just another factor tilting the odds against small investors and ETFs.

Zero-sum game

Options trading is a zero sum game.  An option seller’s gain is a buyer’s loss – and vice versa.  And when this game is played against a contingent of sophisticated ‘Goliaths’ employing teams of investment-savvy computer programmers, there exists little potential for such options overlay strategies to add value to straight stock purchases.

If my arguments haven’t convinced you of this strategy’s poor long-term odds, stay tuned for a forthcoming examination of some older covered call funds’ underwhelming success.


SIDE BAR:  Option Basics

The table below illustrates the basics of call and put options for both buyers and sellers.  If you need to brush up on options beyond the below summary, this online tutorial may help.

BUYER Right to buy Right to sell
SELLER                             (or WRITER) Obligation to sell                (to option buyer) Obligation to buy            (from option seller)

An option buyer pays a premium to the seller.  In return, the buyer gets the right or option to buy shares of the underlying stock at a set price by the expiry date.  Since the option is exercised at the buyer’s discretion, the seller has an obligation to take the other side of the buyer’s trade but in turn pockets the option premium up front.