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.
Swan Global Investments is producing a blog series to address the following questions regarding a number of alternative strategies:
- What are the drivers of returns in each strategy?
- What are the risks in each strategy?
- What role does a given strategy play within a portfolio?
- How does the given strategy compare to the Defined Risk Strategy?
Examining the Covered Call Strategy
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.
Drivers of Returns for Covered Call Strategies
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.
Sources of Risk
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:
- he could close out the trade and take a loss on the option trade;
- the underlying asset could be called away and miss out on the gains;
- the portfolio manager could cross his fingers and pray that the stock reverses direction and dips back below the strike price before being called.
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.
The Role of Covered Calls Within a Portfolio
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.
How Does a Covered Call Strategy Compare to the Defined Risk Strategy?
The Defined Risk Strategy 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 premium collection component, 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. See our previous posts on:
Looking for a deeper dive into portfolio strategies, check out our recently updated white paper on Asset Allocation Strategies.
About the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, 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.
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes nonqualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®). All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. This analysis is not a guarantee or indication of future performance. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. Further information is available upon request by contacting the company directly at 970.382.8901 or visit swanglobalinvestments.com. 061-SGI-030317