Most retail investors use covered call options as a cash generation device. The algorithm generally goes like this: “I’m going to sell a call option at a strike price that I would have sold the shares at anyway – if the stock does not get up to the strike price, I would have held onto the shares, and if the stock goes above the strike I will be cashed out anyhow, so why not make a few pennies selling the call option?”
Unfortunately, such thinking is more damaging than not as investors are usually selling such options at an implied volatility that is lower than what the option should be priced at. Most of this is evident in illiquid option markets (such as the options that trade on most of Canadian issuers on the Montreal Exchange).
The reason selling low-priced covered calls is hurtful is because of the “lottery” aspect of stocks (statistically speaking, this is referred to as the “fat tails” of a price distribution curve) – stocks sometimes do not move in continuous prices, although these jumps do not occur frequently. For example, when selling a call option, you are giving up most of the takeover premium that you would potentially receive. Another example is jumps during quarterly earnings reports. The other significant disadvantage of using covered calls is giving up liquidity – in most retail cases, selling a covered call obligates one to hold the capital in the common shares until expiration, or unwinding the position (which requires paying a spread on less liquid options).
So when somebody is willing to sell you 8 weeks of time on a call option at a strike price that is about 5% away from the money for about 0.8% of the market value of the common shares, they’re probably letting things go for cheaper than they realize. This option is still likely to expire worthless, but the potential upside is far, far better than the price paid simply because it can rocket higher than the 0.8% of premium paid. So I spent a few bucks (far, far less than 1% of the portfolio) on hitting somebody’s low asking price.
Covered calls do have their usage in portfolios, but they typically are constrained to high volatility situations when the action to sell calls seems to be a difficult decision.
I wonder if this might have anything to do with the existence of relatively popular covered call ETFs that simply have to write the calls. It’s not clear to me how many calls the BMO ETFs need to write, for example, but they’re managing about 2bn in assets which is not trivial in terms of the Montreal volumes. They declare that they don’t like to write more than two months out, and I see big dropoffs in volumes beyond that point.
Andrew, this is a very good point. It also reminds me of how futures traders take extreme advantage of ETFs that exclusively deal with holding oil and natural gas exposure strictly through front-dated futures (and unitholders getting totally ripped off when the fund has to do a rollover).
This may be a bit cliche, but the selling of volatility will continue to be profitable until it isn’t. My hunch suggests that the past couple years were a relative low point.
[…] Let’s start things off with Divestor, who pointed out some of the problems with selling covered calls as an income source. Remember one simple rule if you do try such a strategy — the higher the […]