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DRS vs. Covered Call Strategies — Strategy Comparison Series

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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:

  1. What are the dri­vers of returns in each strat­e­gy?
  2. What are the risks in each strat­e­gy?
  3. What role does a giv­en strat­e­gy play with­in a port­fo­lio?
  4. 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.

Covered Call Strategy Diagram | Swan Blog

Source: www.theoptionsguide.com

 

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:

  1. he could close out the trade and take a loss on the option trade;
  2. the under­ly­ing asset could be called away and miss out on the gains;
  3. 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.

 

For more infor­ma­tion on the Defined Risk Strat­e­gy per­for­mance, or its com­po­nents, call 970.382.8901.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout 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.

 

 

Impor­tant Dis­clo­sures:

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[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

By | 2017-08-21T11:58:45+00:00 April 4th, 2017|Blog|Comments Off on DRS vs. Covered Call Strategies — Strategy Comparison Series

About the Author:

As Director of Investment Solutions, Marc 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.