The Covered Call Strategy is highly endorsed by brokers and traders everywhere. The question is does Selling Covered Calls enhance the return of a portfolio? Does it reduce one’s risk/reward profile? Does it attain good value for the trader? Depending on the market, Selling Covered Calls can be an excellent strategy, in most markets however, it has a distorted risk/reward profile. Analyzing the following instruments provides a common sense evaluation of the strategy and its risk/reward profile.
First, and most importantly, let’s be clear, Selling a Covered Call is equivalent to Selling a Synthetic Put. If you’re not comfortable with Selling Puts Naked, then the Covered Call Strategy isn’t for you. Second, due to the Implied Volatility Structure of most Stocks, Standard Stock Indices and Stock Futures, the Implied Volatility of the out-of-the money Calls is often significantly less than the Implied Volatility of out-of-the money Puts. This structure inherently prices equidistant out-of-the money Calls at a cheaper level than out-of-the money Puts. The Table below provides some example of this pricing structure. The Covered Call Strategy encourages the trader to establish a position with, in most cases, comparatively bad value and the Strategy should be executed with caution.
The Table below compares the value of June Apple Puts with June Apple Calls. It shows the disparity of the Implied Volatilities of the out-of-the money options. For example, the Implied Volatility of the Apple Calls is 23.89% while the Implied Volatility of the Puts is 28.28%. To be more specific, the Table shows that the Value of the Call is 1.31 while the Put is 1.55. The striking part of the puzzle is that while the price of the Put is 24 cents higher than that of the Call, the Call with a Strike of 120 is only 9.66 from the current value of the underlying while the 110 Put is 10.34 from the current value. This is a vivid example of how undervalued the Call is. When one trades Options, the idea is to get the best value possible; however, due to the Implied Volatility Skew in most Stocks and ETFs like SPY, there is a significant pricing disadvantage to Selling a Covered Call.
The second example of the Covered Call Pricing disparity is XLE (SPDR Energy Select Trust). In this example, with XLE trading 63.96 shortly before the close on Tuesday, the difference in pricing between Calls and Puts was quite pronounced. Following the same technique as we used in Apple, consider that the 70 Calls were 6.04 out-of-the money while the 58 Puts were 5.96 out-of-the money. In this case the 58 Puts were priced at 93 cents, the midpoint of the Bid and Offer, while the 70 Calls were priced at 47 cents. The Implied Volatility of the Puts was 28.32% while the Implied Volatility of the Call was 21.26%. If one executes a Covered Call Strategy using the Call Strike mentioned, they are limiting the upside of their ETF purchase with a comparatively low priced option and assuming the risk of being long the underlying ETF without a great deal of protection for the downside risk they are assuming.
While trading Covered Calls may make sense when markets are pricing the Calls at a high level, from the two examples we have seen, the Calls are priced inexpensively compared to an Option Contract with similar characteristics (the corresponding Put). Traders should always attempt to get good value in their trades and examining a Covered Call by evaluating the pricing structure of other Options in the Chain will enable traders to establish positions with good risk/reward parameters. There is nothing wrong with making a decision to get Long a Stock or ETF, however, to say you would be happy to get Called on the Stock if it rallies without determining the risk of the trade by comparing an out-of-the money Put limits reasonable risk management analysis.
The final market that is reviewed in the Table is SPY (SPDR S&P 500 ETF). Once again, the idea of executing a Covered Call Strategy is questionable when one considers that the downside risk is so great. Limiting your upside and absorbing large downside risk is an inherently bad strategy. While it seems reasonable for one to get Long the SPY, by Selling a Call against the position and executing the Covered Call, you have sold a Synthetic Put. If you want to be Short Puts, that’s a workable strategy, but, as always, get the best value possible from your trades. Whenever evaluating an Options Trade, evaluate the Implied Volatility Skew and be sure that you are choosing the best Options Trading Strategy to meet you risk/reward parameters. You may find that Selling Covered Calls is not exactly what you thought.
OPTIONS TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. THE INFORMATION IS OBTAINED FROM SOURCES BELIEVED TO BE RELIABLE, BUT IS IN NO WAY GUARANTEED. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.