Covered Call Writing

Discussion in 'Options' started by LoosenUp, Jun 7, 2004.

  1. Hi all,

    I have a question relating to covered call writing. If I have a fund, say 10 mil, and I invest mostly in low P/E or P/NTA stocks(in other words, value stocks) and I sell covered call options on the stocks that I own, can I expect to consistently outperform the S&P? I am not talking about consistent profitability, just consistent outperformance over S&P because of 3 reasons:

    1) I am capturing theta decay and can be expected to win most of the time because stocks trend roughly only 30% of the time. I believe there is an edge in selling. You are the "house".

    2) Even if the stocks do trend upwards, I can continue to roll up and stocks tend to be mean-reverting in nature. Of course, I can still choose to just close off my options with a loss, if I want to if I think that the stock is going to trend strongly upwards.

    3) I can even write some puts on stock I would like to accumulate and earn some premiums while I wait for the opportune time to buy my stocks.

    4) I can even time my sale of call warrants when I predict that the stock has peaked or overstretched in the time frame that I trade. This is not absolutely necessary , though.

    This is such a basic and workable idea and I do not understand why almost 90% (not verified)of funds cannot outperform S&P in the long run.

    Can anybody explain or expand on my thoughts.

    Thanks a lot for any answers or insights.
  2. Hey
    Unfortunately it is a little more complicated than that.

    First, although you capture theta, because the general volatility is low, the absolute premium you capture is small compared to risk.
    Second, you are at risk and if you stay exposed to risk, eventually a multi-sigma event will probably take you out (even if you are hedged, which by the way cuts your profit even more).
    Third, "rolling out" works if you have unlimited funds, however there is a saying (John Maynard Keynes) that the market can stay irrational longer than you can stay solvent. A little firm called LTCM proved this a few years ago, you don't want to prove it again (I hope).
    Fourth, as far as reversion to the mean, you should know that the market has a built in bias to trend that has been in effect for quite a while. Refer back to number three.
    There is a way to sell premium and minimize risk. You have to be willing to hedge by buying protection using index options. This reduces your profit, but at least it gives you a chance to stay alive if a big "event" takes place. A good reference is a book titled "put options" (I think). You might want to give it a look. Best Regards, Steve46

    P.S. By the way, in the interest of giving a balanced picture I should mention that years ago, Ed Thorp and Sheen Kasssof found that selling premium on warrants (before the options market existed) was very profitable if done correctly. they restricted hedging to warrants of less than 4 years duration, and whose stock was selling at less than 120% of exercise price. They claimed that they made about 25% per year net of expenses. Unfortunately this is an opporunity that is very hard to find currently.
  3. There's an index that tracks a diversified large cap portfolio combined with overwrites that at times has outperformed and at others underperformed the S&P. I think it's the BAM index, but my coffee hasn't yet kicked in this morning. Also, the exact components on which calls are sold and the precise parameters in terms of the timing of the writes, etc. escapes me at the moment. However, I'm pretty certain there's no fundamental value-based screen in the selection or timing process. So it's conceivable your approach may be an improvement, though, on the surface, I'm not sure that would make a difference. The main weakness in the strategy, as I recall, is the limitation on upside gains, which would still apply (and perhaps might even be compounded) in the event you had a superior stock selection process.
  4. WarEagle

    WarEagle Moderator

    In the case of covered calls he would not have the risk of being "taken out". His only risk here is underperforming in a ripping bull market. As for the downside risk, he will always be at a slightly better position to a buy and hold portfolio of the same stocks because of the premiums, so its not riskier in that sense. LTCM's problem was the (over)use of leverage. In a value fund, I am assuming that leverage is not used. If the market goes to zero in order to "take him out", then so does the buy and hold and we are all in trouble.

    I think the main problem in comparison to the S&P 500 is the fact that with or without options, you are betting on value stocks outperforming the growth portions of the index. If we go through a growth stock phase, no matter how well you pick your value stocks and improve performance with calls you still may underperform because you are limiting the universe of stocks and as a result are not really comparable to the index. Personally I believe a good stock picker could outperform with covered calls using a more balanced approach with regards to stock selection. It makes total sense to me to write calls when you are within a few points of your target price or write puts when you are a few points above where you want to buy a stock, and I am surprised so many managers do not use this strategy. Of course, this assumes the manager is a decent stock picker to begin with, which is the main reason so few can outperform.
  5. A few years ago, several funds were started to do pretty much this. I don't think they did very well. A lot of portfolio managers use a writing program, but I think theyare lucky to add 2-3 % per year. You give away a lot of upside potential for that.