Advisors Use Covered Calls
According to academic studies approximately 50% of all financial advisors trade options. About 4% of all AUM is in options trading and this number is increasing. The most popular strategy used by advisors is the Covered Call.
Why do advisors use the Covered Call as their core options strategy? What are the pros and cons of this options strategy? Will this strategy protect their clients’ assets in the event of a serious market decline? Does the Covered Call outperform holding long stock over time? Let’s take a closer look at the Covered Call.
First of all. What is a Covered Call? An investor creates a Covered Call by purchasing 100 shares of the underlying, and then selling 1 Call option to offset some of the cost of the 100 shares. By doing this, the trader gets a small discount for the stock, but they limit the maximum return to the upside. The downside of the trade, however, remains fully exposed, just like stock is normally, with the exception of a small discount that was made by selling the Call.
SJ Advisor offers patent-pending options software that can help advisors find the most profitable Covered Call candidates in seconds through instant back testing technology.
Sometimes Long Stock Outperforms Covered Calls
Below, we’ll instantly back test the Covered Call strategy on Google over the last 13 years. Our back test reveals something very interested, maybe something the advisor does not know. Using the Covered Call strategy in this case would have resulted in much lower returns for the advisor’s clients of 1% per month compared to the whopping 3% per month of just holding the long stock.
Selling an OTM Call doesn’t typically bring in much as we see from the image above. In this study GOOG is currently at 532.11 and the 9 delta Call is at $1.13. This would mean that the advisor would pay $53,211 – $113 for a total of $53,211 for this position. The $113 discount is 0.2% per month from the total cost of the trade. If the advisor repeats this Covered Call strategy each month for 12 months, then the total discount would be 2.7% on the year if GOOG does not change. However, if GOOG moves quickly to the upside, then the Covered Call could limit the gains of the stock. If GOOG crashes, then there is a 2.7% buffer, but nothing beyond that. For example, if GOOG drops 30% on the year, the advisor’s clients will still lose approximately 27% on the year using this Covered Call strategy.
Naked Call Performance
In the following image we see the performance of the Naked Call alone. Here, we see an average loss of $984 each month. This represents the average gain wiped out each month that the long stock could have been making if not for selling the Call.
Long Google Stock
In the next image, we see that the 100 shares of long Google stock, without selling the Call each month, outperformed the Covered Call strategy by 300% (3% vs 1% each 32 days). In this case using the Covered Call strategy would have limited Google’s large gains, thus resulting in lower returns over time compared to holding the long stock.
As you can see, the Covered Call may sound like a great strategy, but is it really? On a bullish stock it can under-perform the old-fashioned “buy and hold” method. The Covered Call will outperform the stock if it goes sideways. If the stock crashes, it doesn’t make much difference at all. This is a 10 year case study.
Covered Calls Have Tremendous Downside Risk Exposure
The greatest risk of this trade is to the downside, which you can see in the risk profile images. The Covered Call offers no protection for bearish moves. Even if the advisor diversifies into various products, they still risk the high correlations that go hand in hand during an extremely bearish market. Although products may not correlate in steady markets, often times they do correlate over serious market declines.
If the advisor wishes to use Covered Calls, then we highly recommend to diversify and study the behavior or your assets over serious market crashes. If they all crashed in 2008, 2010 (flash crash) and 2011, then they will surely all crash together again. This would defeat the purpose of diversification.
A better way to protect client accounts is actually to limit the use of Covered Calls to a period that follows a serious market decline. This would increase its safety as well as the income brought in by selling the Calls. When implied volatility is higher, then you’ll get more premium for writing each Call. In addition, the implied volatility will drop more & faster as the market rebounds, which will also help this position to mature faster. However, after a market debacle, the long stock still might outperform a Covered Call over time, so the advisor could eliminate the Covered Call altogether from their investment strategy.
At SJ Advisor, we focus on more sophisticated strategies that do not have so much risk exposure as the Covered Call or limit upside returns like they do. While the Covered Call option strategy is popular, it’s the same risk profile as a Naked Put. If you told your clients you were selling Naked Puts, how would they react to that? The Naked Put strategy is often times a losing one over time because one bad trade can wipe out years of gains. The same holds true for the Covered Call.
Alternative Options Strategies
We can teach you to methods that out perform Covered Calls most of the time and without the downside exposure or limiting upside potential. We can also show you ways to protect your assets over market declines while stock losses can lose from 30% or more. Why put your clients at so much risk when there are much better ways to use options with just a few weeks of education with us? We can teach you in days what took us 20 years to figure out. Options are not simple, but we can help you get past the learning curve.
As a financial advisor it’s of upmost importance to protect your clients’ assets. If you are interested in learning safer ways to implement option trading into your investment portfolio, then please contact us for a free live demonstration.