Disclaimer: in this post I’m going to touch the delicate argument of stock options and my brief experience with them. You should not take what I write here as financial advice. I hate to state the obvious, but the blog is not responsible for any losses you should incur if you follow my strategy.
Hi dear Ripsters,
This is the first post of a short(?) series of posts about my experimentations with Stock Options, in particular with Covered Calls.
In this episode I’ll show you what is a covered call, and why adding them to your portfolio might be a good idea.
I plan to write more posts about my option trades, how to trade options with Interactive Brokers, and… I don’t know yet, it’s a relatively new topic for me! I’ll surely document the evolution of my strategy over time, the mistakes I make, and the lessons I learn.
Your feedback is very well welcome 🙂
Again, managing options is dangerous. like playing with a knife. It can be the most useful tool in the world, but you do one thing wrong and you cut your finger. I’m only using this tool to reduce risk.
As you probably know I’m not feeling confident investing in current stock (and bond) market conditions, but I’m slowly moving my wealth back to a sane asset allocation anyway. Allocation a bit tilted toward an “income”, looking for some hard-to-find yield (VYM, VYMI, VTV), instead of chasing momentum.
My current 2021 performances are modest but positive already, despite the insane percentage of bonds I still hold. And I sleep well at night, which is one of the most important metrics to track, much more important than maximizing my expected percentage returns (which are good anyway).
Please take a look at this amazing article by Nick Maggiulli on the importance of absolute vs relative portfolio performance:
I totally agree with Nick.
I’m doing my best to get my investments in better shape to sustain my financial goals, but I’m always looking for ways to reduce volatility at the expense of some extra return.
The Buy-Write strategy consists in:
- Buying a security: a Stock, a Bond, an ETF, a Future
- Writing (selling) a call option on the same security.
More about the why and the how in a moment.
[Nerd Note: I might mix buy-write and covered call in this post, but I mean the same thing, i.e. covered call. Technically speaking a buy-write strategy means you simultaneously buy an asset and write a call, while a covered call strategy means you write a call on an asset you already own. Yes, minutiae.]
I publicly replied to Nicola (TheItalianLeatherSofa) few days later, presenting some issue I had with understanding the actual strategy.
I didn’t dig any further, and dismissed the recommendation.
The “Covered Call” idea stayed with me for the following weeks, until a friend that we’ll call Mr. F, mentioned it while chatting about investments and individual stocks a couple of weeks ago:
Mr. F: “Yeah, I also invest in a few individual stocks of companies I personally believe in, like Apple. And I make some money on the side by selling Covered Calls 🙂 ”
RIP: “Wait, what? Do you trade stock options? Isn’t it risky? You’re doing this on top of stock picking, are you sure you’re not taking too much risk? Especially today, in this crazy market…”
Mr. F: “I’m actually reducing my risk exposure with my strategy.”
Mr. F works close to CFOs of large non-financial companies. He handles stocks and derivative products as his daily job, but he’s not a salesman. He’s also a Value Investor for fun. I can’t easily dismiss what he has to say on this topic.
Mr. F: “Btw, I guess one of the bloggers you recommended me to read explained this strategy in great detail in a very good post series a few years ago. Didn’t you read it?”
RIP: “Wait, what? Who? Where? When?”
Mr. F: “Early Retirement Now, take a look at his series called passive income through option writing.”
I’ve come full circle. Three bells ringing. I need to dig further now.
I remember having skipped Big ERN series when he first published (2016? Wow, five years ago? I remember like it was yesterday) because “nah, options are risky, I don’t want to go there…”
Big ERN post series on option writing is more focused on (cash covered) put writing, which has a similar risk/reward profile compared to covered calls. Maybe I’ll write a post about short puts in the future, not today though.
Fast forward a couple of weeks: I’ve spent quite a lot of time with Mr. F talking about the Covered Call strategy since our first chat about it, and we’ve planned a shoulder-to-shoulder session together this week (actually this afternoon), with our IB accounts opened, for me to learn more about the subject.
But we’re getting ahead of ourselves.
Let’s start from the beginning:
What is a Covered Call?
I’m fighting against my own instinct of trying to explain everything about Stock Options and Derivatives, but if I walk that way this post series will become a book. A book I’m dramatically not qualified enough to write. I keep repeating to myself: “shorter posts, RIP, stay on topic!”.
But I can’t not provide you at least some context… Ok, here’s what you can do to learn the basics:
- if you have 30 minutes, read the investopedia entries about Call Option, Put Option, and Options Trading for Beginners. The entries have videos, graphs, and links to other interesting entries.
- if you have 1 hour, go into a Wikipedia Option rabbit hole. Ok, an hour will barely suffice to read the linked entry and to open 100 more tabs in your browser so… welcome to my life 😀
- If you have 3 hours, watch this amazing Options Trading for Beginners video by projectoption. Don’t ever buy a crappy ending-in-a-seven priced online course by a lambo-guy on the topic. I saved you $1997, you’re welcome:
“RIP, it’s 2021, my attention span is shorter than a Clash Royale match… I only have 5 minutes. What’s a pull option?”
You lazy ass… Ok, here’s the 5 minute Call Option Primer by RIP.
A Call Option is a contract between two parts, the option buyer and the option seller (also called option writer), where the buyer buys the right (but not the obligation) to purchase the underlying security at a predetermined price (strike price) before a specific date (expiration date) from the writer.
The writer, on the other hand, MUST sell the underlying security at the strike price before the expiration date if the buyer shows up and exercises the option.
The buyer is now in posses of a Long Call Option, while the writer owns a Short Call Option. Yes, a short position. Don’t get scared!
The writer earns a premium (paid by the buyer) for subscribing this contract and giving up some of their freedom. This contract (the call option) can be traded in the secondary market, where the option premium becomes the option price.
Look at a call option as an insurance. An insurance that you can then trade on a particular exchange. The most popular Option Exchange in the US is the Cboe, the Chicago Board Options Exchange.
Note that buying and writing (selling) call options have two different payoff profiles compared to the underlying security:
If you buy a a call option you risk at most the premium you paid (if the security never reaches the strike price before expiration), but your upsides are unlimited:
If you sell a call option your upside is just the premium you cashed, while the downsides are unlimited.
It’s an over simplification but for Call Options with a strike price greater than current market price (Out of The Money Option, or OTM Option) you can think that:
- Buying a Call Option is like buying lottery tickets: low probability of winning, if you win you win big, if you don’t win you lose the money you spent to buy the tickets.
- Writing a Call Option is like running an insurance company: high probability of “nothing happens” while cashing the premiums, with some dramatic downside in case a fatal accident would happen. Like Elon Musk tweeting about the underlying asset, and the price going To The Moon.
“RIP, you’re telling me that you’re selling call options, i.e. you’re exposing yourself to unlimited losses should the underlying security price skyrocket? Are you the guy who sold GME Call options to u/DeepFuckingValue?”
Haha no no, I’m not playing the roulette of course 🙂 Let’s focus on the options mechanic for now, we’ll see what the covered call strategy is later on.
A call option could be sold with or without ownership of the underlying security. In case you’re selling a call option on a stock you don’t own, you’re selling a naked option. This is like playing the roulette! It can only be done on a margin account, and you’ll hear from your broker in case the security price would skyrocket. Don’t try this at home. This is a game for market makers and brokers (and that’s what sent RH close to bankruptcy during the first GME short squeeze of January 2021).
A call option sold while holding the underlying security in your portfolio is called a Covered Call. The unlimited downsides of price skyrocketing are covered exactly with owning the security whose price skyrocketed as well.
Putting things together, the payoff profile of a At The Money (ATM, i.e. strike price = current market price) Covered Call looks like this:
If the security price stays below the strike price until expiration, the option writer cashed the premium and reduced the losses (or made a small profit). If the security price skyrockets, the option writer’s upside is limited to the cashed premium.
Anyway, this is the profile of a ATM covered call. What I’m interested in is Out of The Money (OTM) covered calls. Which are call options with strike price above current market price.
Example (from theoptionsguide.com): I own a stock currently selling at $50. I sell a call options with strike price $55 expiring on date X (not relevant for now) and I cash a premium of $2.
If the stock doesn’t reach $55 until expiration date, I earned $2. If the stocks crosses $55 I will need to sell the stock at $55, limiting my gains to $5 + $2 (premium).
After expiration I can repeat the process at infinitum if the option is not exercised.
Of course, the option premium (or price) is not an arbitrary number but it’s the supply/demand equilibrium price that depends on various factors like difference between current price and strike price, implied volatility of the stock, and time to expiration.
There are indicators, called option greeks (Greek letters: delta, gamma, theta, vega, rho), that explain and predict how the option price changes with volatility, stock price, the passage of time and more.
I hope the mechanic is clear enough and we can move on.
There’s a lot of material available online on Options Trading, and a good chunk of it is aimed to people who want to “play the casino”, or “get rich quick”. Stay away from that. Options are heavy weapons that can be used for multiple purposes. Please do your own research. I’m a novice in the field, and I only plan to use options to reduce volatility (at the expenses of expected returns). I’m here to share my experience and my thoughts as a first principle thinker.
Please, give me feedback, change my mind, tell me I’m doing something stupid if you think so (motivating your answers), help me improve my strategy, get curious/inspired, do more research… the usual stuff 😉
When and Why is a Covered Call Strategy Interesting?
As you know I’m a bit risk averse. I’d happily trade a bit of upside potential for lower volatility and still a good yield.
In my mental model, the only alternative to stock volatility were bonds or cash. Bonds have lower volatility but crappy yields, currently negative in my reference currencies (EUR and CHF). Cash is “taxed” by negative interest rate if you store it in large amounts. I felt helpless.
Covered Calls and cash-covered Short Puts are tools that reduce volatility, whose effect on expected returns might not be that bad, or even positive.
According to Wikipedia:
One well-known strategy is the covered call, in which a trader buys a stock (or holds a previously-purchased long stock position), and sells a call. If the stock price rises above the exercise price, the call will be exercised and the trader will get a fixed profit. If the stock price falls, the call will not be exercised, and any loss incurred to the trader will be partially offset by the premium received from selling the call.
Overall, the payoffs match the payoffs from selling a put. This relationship is known as put–call parity and offers insights for financial theory.
Let’s take a look at the BXM index on Google Finance:
As you can see, the upside slope is limited. The buy-write strategy can’t 10x your money overnight.
How has the index performed since inception compared to S&P 500?
It did great during low volatility times and during slow downturns. It performed worse than S&P 500 during sharp crashed and quick recoveries (welcome 2020!).
Overall, lower volatility and not that bad returns.
Anyway, BXM implements the covered call strategy to an entire underlying stock index (S&P 500) and I don’t know the implementation details of the index I’m looking at. The Cboe website says:
The BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) “writing” (or selling) the near-term S&P 500 Index (SPXSM) “covered” call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.
They picked “one month” as standard duration for the call options (ERN writes options with shorter expiration dates, down to 2-3 times per week), and the strike price is said to be picked “slightly OTM”, which is not much informative. Plus the short call is held until expiration, even though sometimes it seems to be more profitable to buy the call back and write a new one as soon as the residual value is low enough. More on this in future episodes.
“RIP, can you be more quantitative? What yield should I expect? What volatility? Why?”
As Big ERN said:
Better returns and lower volatility? Sharpe ratio up by 40%? Where should I sign??
Of course there’s no free lunch, so this temporary outperformance could be explained in several ways: we live in an era where YOLO traders want to bet more (call options are expensive), and institutional investors want to protect their downside risk more (put options are expensive).
This means that acting as a mini (limited) insurance company is not that bad today, especially if overall volatility will decline.
What could go wrong?
Well, more people might start writing options and the premiums could drop. Or the market might face a sharp decline and enter a depression phase… in that case people won’t bet much and call options premiums would drop.
I’m just speculating here, but the “mini free lunch” traits of options writing could also be explained with “there are not many people doing it, because retail investors think options are risky“.
The risk of this strategy becoming less interesting to me than just investing in stocks is real, but it won’t happen overnight I guess.
Logan Kane called covered call “The Great American Scam”. He showed how a BuyWrite ETF (Invesco PBP) is performing poorly since inception, how tax inefficient the strategy is (not for Swiss investors though), and how calls are badly priced compared to puts – no workaround possible due to arbitrage with synthetic stocks. Good points, still not convinced though.
Well, the PBP returns are very poor indeed, they don’t seem to match the BXM index. Maybe poor execution? High costs? I wouldn’t call the entire strategy a scam though.
Larry Swedroe’s point is more moderate, and it focuses on Sharpe Ratio not telling the entire story, risk being different from volatility, and the “undesirability” of the skewness of the covered call payoff profile that looks like playing a reverse lottery for the option writer. Which is ok if you want to act as a mini insurance. Mind that the skewness of the distribution of returns (high probability of small gains vs low probability of a large losses) is mitigated by the frequency of call options writing. Every time you write a new call you’re throwing another sample in the set, letting the law of large numbers reduce the odds of large losses.
Once again: I don’t aim to maximize my returns. I quoted Nick Maggiulli at the beginning of this post not by chance: I care about meeting my financial needs, i.e. sustaining the highest possible withdrawal rate forever. If I can get 5% expected real returns (instead of 7% historical real stock returns) in a much more reliable way, just tell me where I should put my signature.
Please, also take a look at this great video from projectoption (I love this guy!) on covered call strategy:
Trailer of RIP’s First Covered Call Experience
Maybe someone noticed something weird on my spreadsheet: in mid February I got triggered once again by the emptiness and irrationality of today markets, and the NFT mania. I’ve talked about it in the latest MLJ.
I had to express my disappointment in a boomer way, but also in a way that doesn’t involve buying more crappy bonds (I’m slowly selling them).
So I bought the most boomer stock one can think of: Coca Cola. Relatively stable price, growing dividends since ~50 years (dividend yield 3.3%), a P/E Ratio of 26.48 (high but not insane), a temporary 20% decline in sales in US due to people interacting less with vending machines in Covid times… and I like Coca Cola products. Purchased!
On February 19th I purchased 1000 KO shares, at $49.99 per share (I love this kind of limit orders), i.e. $50k in Coca Cola, or ~3% of my wealth.
Wait, before you kill me: I’m not a cat, I’m not an institutional investor, and I like the stock (cit). KO will find place in my “Value” stock allocation, if I get the chance to hold it.
Mind that I purchased KO because I committed to reinvest 50k per month into stocks, to reach a sane asset allocation before the end of 2021. I didn’t buy KO because I wanted to play with Covered Calls, but as we’ll see in the next episode, I ended up selling KO call options.
Mr. F (who I lately discovered he also owns KO and sell call options) told me that KO is not very good for selling call options because it has low implied volatility (i.e. lower premium), but I don’t mind. Selling calls under high volatility regime has its pros and cons. I’m trying to limit my volatility, so I don’t want to own high volatility assets to make more profits out of options writing.
On March 4th, I wrote my first 10 Call Options on KO: Exp. Date March 19th, Strike Price $52.
Cashed ~$250 for a 4% OTM call option expiring in two weeks, playing with fire around Ex-Dividend date (March 12th, $0.42 dividend), and already experiencing rollercoasters:
But this is a story for another post…
Have a great day!