Stocks & Commodities V. 30:9 (10-22): To Cover or Not? by Markos Katsanos

To Cover or Not? by Markos Katsanos

Covered call writing is one of the most popular option strategies, but there is, of course, a catch. This variation will reduce risk and increase profitability and compare it with related call writing strategies.

Covered call writing has been around for a while, and it may be the most commonly used option strategy, as many investors believe that it produces income without the unlimited risk of naked option writing. In this method, the option investor buys the underlying issue and writes (sells) call options on that same stock in order to generate additional income from the option premium. This strategy has lured many investors and even fund managers, but there is a catch, because there is no such thing as free money on Wall Street.

While covered calls can be a great way to generate income in a flat or moderately up market, the risk in today’s highly volatile market should not be overlooked, as the downside protection that covered calls can create is only the amount of premium received.

The notion that you can enhance your income by writing calls against your portfolio is a delusion because it ignores the damage to your underlying stock portfolio. There is an easy way to find the extent of this damage by looking at the performance of one of the covered call exchange traded funds (ETFs) trading on the NYSE. In Figure 1, you can see a chart of the Madison/Claymore Covered Call Fund (MCN) superimposed on the Standard & Poor’s 500. I have also plotted the same ETF adjusted for distributions (in green).

You can see the damage that option writing does to your principal in the unadjusted MCN (in red). It underperformed the S&P 500 since inception and it has not come anywhere close to recovering to its IPO level. In fact, even after taking into account dividends and distributions (in green), it barely broke even during the seven and a half year period (from August 19, 2004, to December 3l, 2011) compared to a 34% total return for the S&P 500.

This is because of the “fat tail” effect: Stock returns are not normally distributed and most of the big returns or fat losses are in the tails of the distribution. By selling covered calls, you are in effect cutting off the upside (right-hand tail of the distribution) while leaving the left-hand tail (downside) intact. You are therefore vulnerable to potentially unlimited losses and only moderate profits.

This became apparent during the 2008 bear market or the sharp correction in the summer of 2011, as the option premium did very little to protect the option traders from the sharp declines in their stocks. This was more evident in Figure 1, where the adjusted MCN (in green) underperformed during the bull markets in 2006–07 and 2010, while the option premium did little to alleviate the 2008 crisis blowup.

Taking a closer look at the risk curve of a covered call (Figure 2), it is evident why this strategy is not as safe as everyone thinks; it actually has the same risk curve as a naked put! In fact, if you compare the two strategies on a return on account basis, the naked put is superior to the covered call as the margin requirement is more favorable. There is a better way to write call options and take advantage of the time decay without exposing yourself to the downside risk.