August 10, 2014

Covered Calls: The Pros and Cons of Selling Call Options on Your Stocks

Sticking with the option theme of the day, I often hear advice that selling covered calls is the most "conservative" options strategy and is a great way to "generate income". There are even ETFs dedicated to the buy-write strategy. The PowerShares BuyWrite Portfolio (PBP) is the biggest, but you'd have to expect significant excess returns with this strategy with its 0.75% expense ratio. A straight S&P 500 fund like Vanguard's VOO charges less than a tenth of that, at only 0.05%!

Ultimately the idea of implementing a buy-write strategy is that you'll pad your losses a bit if your portfolio goes down, make some extra cash if it stays even or potentially goes up a bit. If your stock goes up significantly, hopefully the covered calls were out-of-the-money and you still get the premium too. What could go wrong?

If you're a long-term investor with a portfolio full of ETFs, the downsides to selling calls, in my opinion, far outweigh the risks. The problems with covered calls come down to three things:
  1. Altered risk/reward profile and opportunity costs
  2. Speculation vs. long-term investing
  3. Tax consequences
Covered calls, covered wagonLet's say you you've got a portfolio with a few low-cost ETFs and you're thinking you'd like to generate extra income selling calls. While SPY and IWM have some of the largest option trading volumes amongst all equities, many long-term investors are heavily invested in broad-based U.S. index ETFs from Vanguard and Schwab, like VTI and SCHB. Owners of many funds, like SCHB, have little in the way of choice if they'd like to sell covered calls. Trading volume is too low. ETFs like VTI do have a decent market for options at multiple expirations in the future.

What's the problem?
Premiums for VTI, for example, are relatively minuscule for short-term calls. VTI currently trades just shy of $100/share. Selling at-the-money call options, a bit over one month out, with a strike price of $100 will net the seller around $1.80/share, or 1.8% of the stock price. This insulates the seller from a small downward correction, but not a large sell-off. In exchange for this premium, sellers also lose out on any large gains. Investors often don't think in terms of opportunity costs, but missing out on potential large gains can be much worse than simply protecting oneself against small losses. Strikes further out-of-the-money are so small, the premium proceeds hardly seem worth it. Ultimately, sellers of covered calls are lessening their risk slightly on the downside, but giving up any potential for large gains on the upside.

Longer-term options on VTI (with a March 2015 expiration, about 7 months out) look more attractive, selling for $4.00 ATM, but strike further OTM drop off in value quickly, and the market can make massive moves in that period of time. Consider this:
  • 2001, VTI has increased by 6.5% or more over a 7-month period more than 50% of the time
  • There is a 25% chance of VTI increasing 12% or more over the course of 7 months
  • 10% of the time, VTI has increased by 18% or more during the same time period!
These are huge gains you are potentially giving up by selling covered calls!

My next issue with selling covered calls is the idea that the seller is no longer an investor, but instead basically becomes a speculator. If the average (and well-above-average) person has no reasonable expectation of predicting what the market will do over the coming months, how can we assume we'll have any better idea as to the magnitude the change? Currently, the market seems overvalued, but bulls have been known to run far past when anyone thought they would end.

Lastly, selling covered calls can force the seller into unintended tax consequences. Premiums collected from the selling of calls will most often be taxed at your short-term capital gains rate, while any contracts that are assigned to the seller may result in paying taxes on capital gains for stock the seller intended too hold long-term.

In short, selling covered calls on your ETFs (or any equities for that matter) may seem relatively safe, but why would you want to limit your upside potential for the sake of a little bit of downside protection? Sticking with a simple buy-and-hold strategy will often trump results from selling covered call options and requires a lot less babysitting of your portfolio.

Take a look for yourself. There are various products including The S&P 500 BuyWrite Portfolio ETF (PBP), CBOE S&P 500 BuyWrite Index ETN (BWV), Horizons S&P 500 Covered Call ETF (HSPX), and even a sector-specific S&P Financial Select Sector Covered Call ETF (HFIN). You'll notice over time that most of these products tend to lag their respective indexes. They each provide a little bit of cushion in a downturn, but lose out the biggest upside swings.

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