An investor who types "covered calls" into an Internet search engine is likely to see a message such as this one: "I Love Covered Calls. I Make 8% -10% Gains Every Month with Covered Calls and Option Spreads." Apparently, covered calls have moved from hyper-complicated to well-hyped.
Few financial planners believe that any type of investment will deliver returns of 8% to 10% every month. Some planners insist, however, that such a return is possible - on an annual basis - with strategies that include covered calls. "I've been using covered calls since 1982," says Ronald Heakins, founder and president of OakTree Investment Advisors in Pittsburgh. "Counting dividends and capital gains and option premiums, our clients have been able to get annualized returns of 10% to 12%."
Similarly, with 30 years of experience, H. Parker Evans, president and chief investment strategist of Successful Portfolios in Clearwater, Fla., adds: "Covered calls offer better-than-bond yields. We like writing covered calls and have made money for our clients with them."
But with such potential rewards come drawbacks, according to Todd Salamone, senior vice president of research at Schaeffer's Investment Research in Cincinnati. "When discussing covered calls," he says, "financial planners should make clients aware that they're limiting the upside potential of their investments in stocks. That's often missed in presentations on this strategy."
CRACKING THE CODE
The strategy, sometimes known as "buy-write," consists of buying or owning a stock or shares in an ETF, then selling ("writing," in options lingo) an option to purchase ("call") those shares. Since the client holds the underlying stock or ETF, the potential option execution is covered, meaning the only risk is potentially missing out on some upside.
Buy-write plans are complicated by the fact that a publicly traded stock and ETFs may have many listed call and put (sell) options, at various strike (execution) prices and expiration dates. In late July, for example, the Quotes & Tools section of the Schaeffer's Investment Research website listed more than 30 call options of JPMorgan Chase that were set to expire in August, at strike prices ranging from $16 to $55 a share. Similar variety was offered in September options, October options and so on out to December 2014.
Options experts believe that mining such data will reveal gems. On the Seeking Alpha website, a contributor signing in as "Covered Call Strategies" offered this tip: With JPM trading at $35.17, own the stock and write an October call with a $39 strike price. If a client owns 100 shares of JPM, worth $3,517, selling a call with a 53-cent bid price will bring in $53, about 1.5% of the shares' value, for an option expiring in less than three months. Annualized, this action would produce a yield of 5.73%. Add that to the stock's annual 3.67% dividend yield and the total annualized yield to the client is 9.4% - certainly appealing in a period with historically low Treasury yields.
But that hypothetical 9.4% return assumes a string of future events. First, it assumes that JPM shares don't top $39, so the shares won't be called away before the October expiration date. Second, it assumes that in October the client can write a similar call and receive a similar premium. If this goes on for 12 months, the actual return would be about 9.4% of the shares' July 2012 value. "In a flat market, such a strategy can work well," Salamone notes.
But individual stocks may not stay nearly flat indefinitely. A client selling a $39 call on a stock selling for $35 is writing an "out of the money" call, meaning the strike price is higher than the trading price, so the option has no intrinsic value. Such an option becomes "in the money" if JPM's shares top $39. If that happens and the shares are called away, the investor would have a gain of around 11% in three months, on top of the option premium and the dividend received while holding the shares. An option exercised at $39 would limit the potential profit for the investor, however; he would miss the opportunity to sell at a higher price if JPM keeps climbing.
Going the other way, JPM might drop to $30 or less. Collecting a 53-cent option premium would reduce the loss a smidgen, but certainly wouldn't remove the risk faced by all stock market investors. A client who still holds JPM could sell another call and hope for better results the next time around.
Are there some basic strategies that can help planners find profitable opportunities for their clients in covered calls? Heakins tunes his tactics in line with his firm's business-cycle analysis.
"If we think we're in an economic expansion, we'll sell out-of-the-money calls," he explains. "When we see a contraction, we'll sell at-the-money or in-the-money calls. We believe another recession is coming now, so we're selling in-the-money calls to take some risk off the table."
In a blog post on the OakTree website, Heakins' son Jason provides an example. He suggests buying Southern Co., an electric utility, for $47.56 a share and selling a slightly in-the-money call, expiring in January 2013, at $47. If the option isn't exercised, the call premium plus the dividend would generate a 10.43% annualized yield; if the option is exercised and the investor takes a loss on the stock (bought at $47.56, called away at $47), the option premium plus the dividend would still provide a 7.48% annualized return, he says.
If a call writer sees that the shares will be called away, buying back the option is a possibility. This buyback would generate a loss on the option if the stock has appreciated, but the investor will still hold the shares and be in a position to benefit from future gains.
"I generally won't buy back the option," says Evans of Successful Portfolios. "Clients typically like this strategy for the consistent income they receive."
Nevertheless, Evans warns against buying a stock and writing a call just because of an attractive call premium. "We buy stocks that we want to own," he says, "and usually sell out-of-the-money calls." This gives his clients option premiums, dividends and the chance for capital gains if the option is exercised.
"Executing these strategies is very labor-intensive," Evans says, "but the idea of receiving ample cash flow without taking credit risk in the bond market resonates with clients and prospects. This strategy helps us differentiate our firm from other advisors."
The promised benefits of buy-write strategies may not persuade some planners to enter into such labor-intensive pursuits. As an alternative, there are many covered-calls funds from which to choose: some of these funds invest in individual stocks or ETFs and write calls on a majority of their holdings while other funds write calls on broad stock market indexes.
"Most covered-call funds are closed-end funds," says Cara Esser, a closed-end fund analyst at Morningstar. "Many of these funds were launched in 2004 and 2005, when the idea became popular." Thus, covered-call funds may have records that span five years, but not 10.
Since the initial growth spurt, few covered-call funds have been created. "Investors and advisors soured on them," Esser says. "For one reason, some of these funds maintained their distribution rates by returning capital to investors."
Currently, Morningstar lists 42 closed-end funds that follow a covered-call strategy, including six with more than $1 billion in assets. The sizable fund with the best five-year record is Eaton Vance Tax-Managed Buy-Write Opportunities Fund (nearly $900 million in assets), which had an annualized return of a bit more than 5% for the five years that includes the first half of 2012. "In general," Esser says, "closed-end covered-call funds did relatively well in the 2008 crash, because the option premiums reduced their losses, but they lagged in the recovery of 2009 and 2010."
Going forward, a covered-call fund could be worth a modest portfolio allocation for an advisor to consider. "Historically," Esser says, "implied volatility has been higher than actual volatility, raising the price of options, so call writers generally are being paid higher prices and taking less risk. Covered-call funds aren't required equity holdings," she adds, "but they might provide investors with some diversification, extra income and downside protection."
Donald Jay Korn is a contributing writer in New York for Financial Planning. He also writes regularly for On Wall Street.