I was very excited when I heard that the ASX had published a research paper on covered call (buy-write) returns. One of the most common questions that I get asked is “how much returns can I expect from doing covered calls?” Finally, I have a credible reference to help to answer this question. The title of the paper “An Encyclopaedia of Australian Buy-Write Returns (April 2005 – December 2011) sounds pretty dull but the findings from that study are far from dull. The period of study was chosen to include a Bull Market (April 2005 – June 2007), a Bear Market (July 2007 – February 2009) and a Neutral Market (March 2009 to December 2011).

As there are many ways of selling covered calls, the study was performed using seven different covered call strategies (Basic, Sell signal, Momentum, Volatility, Delta, Periodic and Ex-Dividend). The key findings of this study are –

  • Over the whole time period, each buy-write strategy generates a higher risk-adjusted return relative to a long-only stock portfolio.
  • The best performing strategy is the Delta Strategy, which generates the highest risk-adjusted return amongst all the strategies.
  • The weakest strategy is the Volatility Strategy, which generates the lowest risk-adjusted return amongst all the strategies.
  • The outperformance of the different buy-write strategies is greatest during the bear market period of July, 2007 to February, 2009.
  • The buy-write strategies generally underperform during the bull market period of April, 2005 to June, 2007.

Over the entire period of the study, the poorest performing covered call strategy still outperformed the long only portfolio by roughly 20% and the best performing strategy outperformed by 60% as shown in the chart below.

Source: An Encyclopaedia of Australian Buy-Write Returns (Apr 2005 – Dec 2011)

The Delta Strategy (orange line) is clearly the best performing covered call strategy; hence it is not surprising that it has been given a 5 star rating by Eureka Report’s Investment Road Test on Covered Calls. One of the reasons why I like the Delta Strategy is because it uses hard coded rules to govern the overall position management. In the ASX study, calls are sold at 5% out of the money and the Delta strategy triggers a buyback of the sold call option when its “delta” rose to the level of 0.85.

As a practitioner of covered calls, I know how hard it is to decide when to sell a call and when to buy it back. When you sell a call, you are limiting your upside so if the stock price rises, you would wish you had not sold the call. I sometimes find I will hesitate to sell calls when I see the stock rising strongly (like ILU, one of our Model Portfolio stocks did in July). I wait too long to sell the call and the stock falls again.  Likewise if the stock is rising strongly after I sell the call (like NCM in our model portfolio), I may hesitate to buy it back as I have to realise a loss in my call option in exchange for unrealised gains in the stock which might evaporate in the next few weeks. Without a proven system on when to “roll the calls” (i.e. buy back one call and sell another higher one), you tend to rely on experience and “gut feel” which, I have to agree, is not the best way for executing any strategy.  I am really glad that now there is solid evidence to show that the Delta Strategy works and I will start to use this in managing our Model Portfolio immediately.  It is also fortunate that we have recently swapped over to the Halifax TWS platform as we can configure our option chains to show the “delta” of each option which makes managing our positions using the Delta Strategy so much easier.

Source: Halifax Trader Work Station

While the Delta Strategy produced the best returns for the entire portfolio of 30 stocks, I wondered if it was the best strategy for each stock. We all know that Australia has a two speed economy – “mining” and “non-mining” which is also reflected in our stock market. We have mining stocks which are typically the “growth” stocks that pay very little dividends, and we have the “income” stocks that pay good dividends but produce little growth (although of late our income stocks seems to  behave more like growth stocks). The ASX paper also provided the results for each individual stock so I decided to look up a few of those that we have in our model portfolio. The Delta Strategy worked really well for growth stocks such NCM when we compare it with the Ex-Dividend strategy. With a dividend yield of 1%, it is not a surprise that the Ex-Dividend strategy did not work so well for NCM.

Source: An Encyclopaedia of Australian Buy-Write Returns (click to enlarge)

However, the results were quite different for an income stock like TLS where the Ex-Dividend strategy outperformed the Delta strategy.

Source: An Encyclopaedia of Australian Buy-Write Returns (click to enlarge)

If you understand how options are priced, it is not hard to understand why the Delta Strategy works better for growth rather than income stocks. One of the biggest factors that affect the option price is Implied Volatility (IV). As you can see from the option chains below for NCM and TLS, the IV for TLS is much lower compared to NCM. Hence the option premiums for income stocks such as TLS would tend to be lower than growth stocks such as NCM, and hence cannot improve the returns over a long only portfolio by much.

Option chain for NCM calls:

Source: Halifax Trader Work Station

Option Chain for TLS calls:

Source: Halifax Trader Work Station

For the Ex-Dividend Strategy, stocks are purchased and slightly ITM calls (with delta of 0.7 or less) are sold one day before a stock goes “ex-dividend” and held for 46 days in order to comply with the ATO’s “45 day rule” for receiving franking credits. Dividends and franking credits provide most of the returns for income stocks. The call options are mainly for protecting the downside risk in the stock price as income stocks tend to fall in price immediately after the stock goes “ex-dividend”.

The Ex-Dividend strategy is very similar to what I have been doing (see my trade set up for TLS in the June 20 Weekly Portfolio Update). However, I normally let the stock get called away when the option expires rather than close the position after holding the stock for 46 days to avoid paying commissions that would be incurred for closing the call. If commissions are not too high, closing the trade earlier is better as it means we get our cash back earlier so it can start earning interest in the bank. I have always found this strategy to work well for income stocks so it is good to have the study validate my findings as well. We will use the Ex-Dividend Strategy to manage our positions on income stocks in our Model Portfolio.

The ASX study was purely on covered calls and did not include selling puts. One of my favourite strategies is to sell slightly ITM cash secured puts on income stocks after the stock goes “ex-dividend” (like our NAB and WDC trades in the Model Portfolio) to try to earn a little extra income in between dividend payouts. We will continue to sell puts to generate extra income (if our puts do not get exercised) or to buy stocks at a discount (if they do) in our Model Portfolio.

By selecting the most appropriate covered call strategy for each type of stock, and selling puts, I believe our returns can be even better than simply applying the Delta Strategy for all stocks in our portfolio. What shall we call this strategy? The Delta++ Strategy? The “All Stars” Strategy? Leave a comment if you have a good name suggestion. A prize of two movie tickets will be given to anyone who can come up with a really good name.

Note: Due to other commitments, there will be no Weekly Portfolio Update today. ECB announced unlimited bond purchases last night so markets should be celebrating today. Have a great weekend!

One Response to Covered Call Returns in All Market Conditions

  1. Great article, there have been numerous academic studies that show that covered call writing can enhance portfolio return and reduce risk.

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