Covered Call (Buy-Write) Gold Rush

tfmckeon's picture

In the past few months, there has been a flurry of interest in covered call strategies, with new product launches from several of the usual suspects ( and some new ones ) and one prominent search commenced for these options-based hedging strategies . As icing on the cake,  S&P Dow Jones Indices just announced their new index, designed to track a dynamic covered call strategy based on the S&P 500.

We are pleased to see that other product manufacturers, institutional investors and index vendors are beginning to understand the power of these hedged strategies. We welcome the activity and attention that new indexes, fresh product launches and institutional search activity represents.  Covered calls can be very productive return-enhancing and risk-reducing strategies.   The more, the merrier,  although we prefer to describe the approach as “buy-write”.

But, we note that the recently-launched covered call/buy-write products, are largely complex, expensive and tactical, with their embedded complexity and active management component invoked to justify their high fees.  We don’t see the need for that and we believe that it’s likely to be self-defeating.

Positioning Dilemma

We have also observed a peculiar positioning approach taken by the new buy-write product sponsors and index vendors.  A buy-write (okay,  covered call) strategy has a well-defined payoff profile: They outperform similarly-constructed, long-only strategies in all market scenarios except for strong up-markets. The white paper offered by S&P Dow Jones Indices that explains their approach to the new covered call index agrees with this premise and states: 

“Covered call strategies generally outperform an outright long allocation except during a significant rally.”  (Click here to see the full paper.) 

No argument there and it echoes the on-the-ground facts well understood by anyone with a modicum of option investing experience. But, the developing pitch for these new products doesn’t leave that well-enough alone.

Since it is well-known which market regimes favor buy-writes and which don’t, they seem to be promoted within a tactical package. That packaging sounds like this: “when you expect an upmarket, you can trim or exit the buy-write strategy and when you expect normal, sideways or down markets, you can expand your buy-write allocation.” 

There is just one little problem. If you know where the markets will be in the future, you can dispense with asset allocation and diversification and all the other prudent, rational techniques used to reduce risk and maximize returns. For that matter, you can dispense with options-hedging entirely and leverage the portfolio to the max.  Just put all your (clients’) money on 33 Red and everything will work out, right? 

We all know that is imprudent and not the way serious money is invested, because no one knows what the future holds, with any degree of certainty.

We at CSCM have taken the approach that allocations to our low-cost, liquid and rules-based hedged strategies merit a full-time allocation within a well-diversified and allocation portfolio. The historic risk and return data of the hedged benchmarks and our own composite history supports that notion and the unpredictability of the real world reinforces it.

The recent (June 2013) RFP from CalSTRS for a covered call / low volatility strategy states the essential proposition of buy-writes most succinctly: 

“CalSTRS wishes to maintain its equity exposure with significantly reduced risk, and to mitigate tail risk.” 

Sounds good to us.