Jan. 4, 2021
Insight Series – Comparing Hedging and Options Strategies
Strategy Comparison Series
With a covered call, the manager holds an underlying position on individual stocks or an index-like position. However, the manager seeks to supplement their return by systematically selling calls against their long positions and collecting that option premium. For more on a call option, see here.
Below is a graph outlining the return profile of a covered call strategy, with the underlying stock as the dotted line and the combined equity-and-short-call return profile as the solid line.
Seeking Portfolio Protection vs Portfolio Cushioning
Options strategies are increasingly becoming more accepted as a tool the portfolio construction. One of the most common option-based strategies is the covered call.
All options-based strategies are not created equal. However, many investors tend to lump all strategies that utilize options together. This is an erroneous approach, as different strategies have very different objectives and different ways of utilizing options.
With a covered call strategy the lion’s share of the holdings are in a buy-and-hold position in a stock or index. While the collection of option premium might supplement the returns, the primary driver of a covered call strategy will most likely be simply the upward or downward movement in the stock price.
While the covered call strategy sounds like a clever way to supplement return with income, there are two major risks associated with it: one on the upside and one on the downside.
The first risk is on the upside. If the markets take off too quickly, the call option goes in-the-money. Under such circumstances the portfolio manager really only has a few options:
Regardless, the covered call has effectively sold off its upside potential in a sharply rising market.
The other risk is on the downside. A covered call strategy offers no downside protection. The long position is unhedged and completely exposed to losses. The income from the sale of calls might offset a bit of the losses, but in a situation where the market sells off 20%, 30%, 40% or more, it is highly likely a covered call strategy would face similar losses.
Using a dated but still useful nomenclature, a covered call strategy essentially transforms a “growth” position (i.e., a long stock) to a “growth and income” play. The potential for larger gains is in effect swapped out for immediate income. In a low-yield world where dividend-paying stocks are trading at a premium, this type of approach might boost income if it works out.
The ideal scenario for a covered call strategy is a slowly rising market, where the equity position gains but never moves past the strike price of the call option. In such a situation the portfolio can collect income from the sale of calls, but not worry about having its market gains being sold away. Sadly, this situation doesn’t accurately describe much of what we’ve seen over the last decade or more. Either markets were selling off massively (2007-08) or rallying significantly (2009-10, 2012-2016). Neither situation is good for covered call strategies.
The Defined Risk Strategy (DRS) shares a few similarities with covered calls, in the sense that it has a core, buy-and-hold, long position and does sell options on that underlying long position. However, there are some key differences between the DRS and covered call strategies.
The DRS is better described as a hedged equity approach, where there is explicit downside protection on the equity in the form of a long-term LEAPS put option. There is a third component comprised of shorter-term options seeking premium collection, but the income is generated via the simultaneous sale of both calls and puts in a market-neutral fashion. All this leads to a very different return and risk profile than covered call managers.
The objective of this Strategy Comparison blog series is to help investors, and advisors, better understand these non-traditional strategies and how they compare and contrast to the DRS when making portfolio decisions.
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Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.