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An Overview of Covered Call Writing

Richard Croft
June 3, 2013
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12 minutes read
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Covered call writing reduces equity risk and provides tax advantaged cash flow. It is not a panacea, which means it is not a standalone investment strategy. It works best when combined with other assets within a broadly diversified portfolio.

You can execute a covered call write by buying say, 100 shares of Blackberry (TSX: BB) at $14.45 per share and writing one (note each option contract is exercisable into 100 shares of the underlying stock) Blackberry September 15 call at $1.65.

By selling the Blackberry calls you are obligated to deliver to the call buyer 100 shares of Blackberry at $15 per share anytime between the time the calls are written and the September expiration date. Options expire on the Saturday following the third Friday of the expiration month.

The covered call strategy does three things for the investor; 1) provides tax advantaged incremental cash flow, 2) reduces downside risk and 3) establishes a price at which we would be willing to sell shares.

The premium received represents incremental income which in the Blackberry example was $1.65 per share. That premium is taxed as a capital gain.

The premium also reduces the cost of the underlying shares which effectively reduces your risk. In the Blackberry example the $1.65 premium reduces the out-of-pocket cost of the shares to $12.80.

The out-of-pocket cost is also the starting point when assessing the potential return from the covered call strategy. In this case, the upside is limited to $15 per share… the strike price of the call. The net investment is $12.80, which, assuming the stock is called away, translates into a total return of $15 divided by $12.80 or 17.2% between now and the September expiration. If the stock paid a dividend you would add that back into the total return.

The strike price can be viewed from two perspectives. As a glass half full the strike price establishes a point at which you should be willing to sell the underlying stock. As a glass half empty the strike price sets a limit on your upside potential.

That latter point has led some analysts to contend that covered call writing is not a very good long term strategy because investors end up losing their best performing stocks. That point is relevant, which is why we always evaluate whether the incremental cash flow and risk reduction metrics are sufficient to offset the negative repercussions from having good stocks called away. In some cases we have repurchased the calls before expiry in order to retain a particularly attractive stock.

Covered Call Myths

Covered call writing has been marketed by some as a strategy that changes the odds in the investment game. Much like counting cards does at the blackjack table. The underlying principal is based on the “rollover effect,” where investors theoretically sell short term (i.e. one month) calls and roll the position forward each month. The compounding of monthly returns leads to a domino effect that, when worked to perfection, allows one to double their money year over year.

The idea is to find volatile stocks that, by definition, have the highest option premiums. Write the at-the-money near month calls where the time value erodes at a faster pace, wait for the stock to be called away and repeat the process. Assuming you earn 10% if the shares are called away month after month you double your money in less than a year. A $5,000 investment grows to $1 million in just over 4 ½ years! Of course that’s the same as saying if your aunt was a man she would be your uncle.

Clearly manipulating returns with questionable metrics is a fatally flawed approach. It might work if a stock were going straight up for a prolonged period of time but assuming that would not buy and hold work just as well?

In a bear market it simply doesn’t work, and should a stock be locked in a trading range for a prolonged period, option premiums would eventually contract lowering the potential of the strategy. In my mind, consistently writing short term at-the-money calls is not an answer for an investor seeking growth.

A better approach is to stretch out the term of the covered call. You also want to apply some technical guidelines to enhance the timing and increase the probability of a successful trade. Finally, covered call writing is but one strategy that should be a component within a broader well diversified portfolio.

One approach to time the covered call is to use technical indicators, like Bollinger Bands, which were created by a California based technical analyst, John Bollinger. Bollinger Bands are similar to moving average envelopes in that they frame the current price of the stock. These moving average envelopes represent one or two standard deviations (the degree of separation can be set by the user) above and below a moving average. The width of the Bollinger envelope is determined by the historical volatility of the underlying stock and is self-adjusting. As the stock becomes more volatile, the bands widen as it stabilizes, meaning that volatility is contracting the bandwidth narrows.

But what does it mean? According to Bollinger, who originally designed the bands as a tool to predict price movement, price changes tend to occur after the bands tighten as a result of contracting volatility. When prices move outside the bands, a continuation of the current trend is implied. Bottoms and tops made outside the bands, followed by bottoms and tops made inside the bands, imply a reversal in the trend. And finally, a move that originates at one band tends to go all the way to the other band, which some technicians use to project price targets.

Rather than using Bollinger Bands to predict price movements, you could use them as a tool to set potential prices at which you could write covered calls. For example, selling a covered call that reduces your out-of-pocket cost to the lower Band, while using the upper band as your maximum potential profit zone.

You could also add other technical indicators as confirmations. The Relative Strength Index (RSI) being a case in point. For example, if you like a particular stock that is currently at the upper Bollinger Band, you might want to look for the RSI to be greater than 70. In that instance, you could buy the shares and write an at-the-money covered call that would trigger a sale just above the band.

Similarly if you were looking at a stock whose price is at the lower Bollinger Band, look to confirm the trend with the RSI. In this example, you would want to see the RSI below 30.

You should also be mindful of the role that the trend plays in this process. If the stock’s price is at the upper Bollinger Band and the RSI is less than 70, technicians would expect the trend to continue. If the stock is rising, it will continue to rise and vice versa. If the stock’s price is at the lower Bollinger Band but the RSI is greater than 30, that trend will likely continue. If the stock is declining it will continue to decline, if it is rising it will continue to rise.

These tools do not eliminate the need to evaluate companies on the basis of their fundamentals. They simply help with timing and how we set specific strikes.

The Relative Strength Index

The name Relative Strength Index (RSI) is slightly misleading, in that the RSI does not compare the relative strength of two securities. Rather, it focuses on the internal strength of a single security. A more appropriate name might be “Internal Strength Index.” When we want to look at charts that compare two market indices,, they are usually referred to as Comparative Relative Strength.

Welles Wilder, in his book “New Concepts in technical Trading Systems,” provides step by step instructions on how to calculate and interpret the RSI. Essentially, the RSI is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the RSI is to look for divergences. For example, when a security is making a new high but the RSI fails to surpass its previous high. A divergence is an indication of an impending reversal. When the RSI then turns down and falls below its most recent trough, it is said to have completed a “failure swing.” The failure swing is considered a confirmation of the impending reversal.

In Mr. Wilder’s book, he discusses five uses of the RSI in analyzing commodity charts. These methods can be applied to other securities as well.

• Tops and Bottoms: The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.
• Chart Formations: The RSI often forms chart patterns such as head and shoulders or triangles that may or may not be visible on the price chart.
• Failure Swings: (also known as support or resistance penetrations or breakouts). This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).
• Support and Resistance: The RSI shows, sometimes more clearly than price themselves, levels of support and resistance.
• Divergences: As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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