Are covered calls too good to be true?

By LARY SWEDROE

Investors are interested in increasing returns without having to accept more risk. Thus, they are attracted to the “promise” offered by marketers of the strategy of writing “covered calls”. The question is whether or not it is an efficient strategy. To determine if that’s the case, the returns of a covered-call strategy should be compared to a similar passive strategy that invests in the same asset class but does not employ covered calls. We begin with some definitions.

What is a covered call?

A “call” is an option contract that gives the holder the right, but not the obligation, to buy a security at a predetermined price on a specific date (European call) or during a specific period (American call). A “covered-call” strategy requires the investor to write (sell) a call option on stocks that are in the portfolio. In return for transferring to the buyer of the option all the potential for movement above the price at which the option can be exercised, the seller receives an upfront premium.

If the call expires without being exercised, the portfolio return is based on the call premium and the value of the stock the call writer still owns. Alternatively, if the call is exercised, the call writer receives the call premium and surrenders the stock at the strike price. One “cost” (besides transaction costs and taxes) of the covered-call strategy is the lost upside opportunity. Essentially, the covered-call investor is trading off the upside potential of the equity investment for an upfront fee and reduced (by the size of the call premium) exposure to downside risk.

Marketers of covered-call strategies demonstrate their efficiency through the use of a risk-reward measurement tool known as the “Sharpe ratio”. The Sharpe ratio is a measure of the return earned above the rate of return on riskless short-term U.S. Treasury bills relative to the risk taken, with risk being measured by the standard deviation of return. For example, assume the average return earned on an asset was 10 percent, the average rate of one-month Treasury bills was 4 percent, and the standard deviation was 20 percent. The Sharpe ratio would be equal to 10 percent minus 4 percent (six percent) divided by 20 percent, or 0.3.

While the Sharpe ratio is a useful risk-reward measurement tool, implicit in its definition is that standard deviation is the only measure of risk. While standard deviation does measure the volatility of returns, volatility is not the only measure of risk. Investors care not only about volatility but also about other characteristics of the distribution of returns. They care, for example, about skewness.

Positive and negative skewness

“Skewness” measures the asymmetry of a distribution. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from the mean than the values to the right. For example: the return series of -30 percent, 5 percent, 10 percent and 15 percent has a mean of 0 percent. There is only one return less than zero percent and three higher, but the one that is negative is much farther from zero than the positive ones. Positive skewness occurs when the values to the right of (more than) the mean are fewer but farther from the mean than the values to the left. Investors prefer assets with positive skewness, like a lottery ticket. They generally try to avoid assets with negative skewness.

This leads us to the question of what impact a covered-call writing strategy has on the potential distribution of returns. Does it shift the distribution away from a normal one, rendering the use of measures such as the Sharpe ratio less meaningful?

Karyl Leggio and Donald Lien, authors of the study Covered Calls: A Lose/Lose Investment, published in the May 2005 issue of the Journal of Financial Planning and covering the nine-year period February 1987 to December 1995, found that while covered-call strategies did produce a lower standard deviation than an indexing strategy, because the covered-call strategy eliminates the upside potential, it produces negative skewness of returns (the kind investors dislike). For example, using a strategy of one-month covered calls produced a negative skewness of 4.6 versus a negative skewness of just 1.1 for a buy-and-hold indexing strategy. The negative skewness calls into question the relevance of the Sharpe ratio for this strategy.

Good and bad fat tails

While it is true that a covered-call strategy does reduce kurtosis (fat tails), the problem is that it eliminates the potential for the good fat tail (the one to the right) while having no impact on the risk of the bad fat tail (the one to the left), only reducing its size by the amount of the premiums collected. Risk-averse investors would much prefer that it be the other way around — eliminating the risk of the left fat tail (bear market) while accepting a smaller right fat tail (bull market).

We see clear evidence of this preference in the pricing of puts and calls. Consider a stock selling at 100. The price of a call at 105 is typically much less expensive than the price of a put at 95, yet both are the same distance from the strike price, and investors have limited downside risk (you can only lose 100 percent of your investment) and unlimited upside potential.

You also can see this when pricing “zero-cost” collars. In this example, in order to have the cost be zero, if the strike price of the call was 105, the strike price of the put might have to be 90. Most investors, being risk averse, care much more about the downside risk than the upside. And covered calls only reduce the downside risk by the price of the call, but give up all the upside potential beyond the strike price.

There are two other issues to consider: taxes and transaction costs. Covered call strategies result in tax inefficiencies because some or all of the income (depending on whether one is writing options on indexes or individual stocks) will be treated as short-term capital gains. On the other hand, the foregone capital gains that are lost when options are exercised are taxed at capital gains rates. And compared to passive buy-and-hold strategies, covered-call strategies entail high transaction costs. The high turnover results in costs related to both commissions and bid-offer spreads, and possibly market impact costs as well.

Summary

While covered-call strategies seem to promise a free lunch in the form of similar returns with lower volatility, investors who care about more than the volatility of returns will not find them to be efficient.

Even for those investors for whom the value of the limited downside protection gained exceeds the value of the foregone potential upside benefits, we believe there is a more efficient way of achieving the same objective. This can be accomplished by lowering the equity allocation and increasing the allocation to high quality bonds (providing downside protection) while also increasing the exposure to small and value stocks (increasing the expected return from the equity portion of the portfolio). This strategy is discussed in detail in my book, co-authored with Kevin Grogan, Reducing the Risks of Black Swans.

For those interested in accessing the volatility risk premium (VRP), another alternative is to invest in a fund such as Stone Ridge’s All Asset Variance Risk Premium Fund (AVRPX), which buys and sells puts and calls on a wide variety of stocks, bonds, commodities and currencies.*

* Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge funds in constructing client portfolios.