Would you be interested in a conservative stock strategy that increases your income while reducing volatility -- while forfeiting only some of your upside potential? Of course you would.
Consider, therefore, a call-writing strategy. The approach calls for selling call options (“writing” calls) against the stocks you already own. Depending on how the strategy is executed, and depending on what the market does, the approach can live up to the claims I note at the top of this column.
Several of the investment newsletters I monitor have highlighted this strategy in recent months, no doubt in reaction to the market’s extraordinary volatility earlier this year and concern that the bull market won’t last forever.
The call writing strategy doesn’t always work, however. And even when it does, you need to follow it with patience and discipline over time. The devil is in the details.
A Call-Writing Illustration
To illustrate, imagine that you own 100 shares of Apple, which for this example, are trading at $124.40 per share. You can sell an option for someone else to buy your shares at $140 a piece anytime between now and Nov. 20 and pocket $2.28 per share (the premium). If Apple doesn’t reach $140 between now and Nov. 20, you get to keep that $2.28 premium -- which is equivalent to increasing your annual dividend yield by 18%. And if Apple does reach $140 between now and Nov. 20 and your shares are called away, you will pocket a quick 12.5% return in just six weeks’ time.
Sounds like a heads-I-win, tails-you-lose proposition.
What can cause the strategy not to work out? There are several different factors:
If you want to reduce the chances of your shares getting called away, you can choose a higher strike price of the call options you sell (write). But if you do that, the price you get for selling the calls will be correspondingly lower.
If, in contrast, you want to increase the amount of income you get from writing the calls, you will need to pick a lower strike price. But that increases the chances of your shares getting called away.
Note that the overall return of a call-writing strategy depends also on the performance of the stocks against which you have written the calls.
As a general rule, the strategy will be a laggard when those stocks are rising. And it will come out ahead when those shares are falling, since you will get to keep the shares you own and still pocket the premium from writing the calls. The strategy also will tend to perform better when those stocks have been exhibiting greater volatility.
Investors often overlook this relationship between the market and the performance of the call-writing strategy. If you were supremely confident that the market in general, and your shares in particular, were about to rise strongly, you wouldn’t want to pursue a call-writing strategy.
That does not pose an obstacle to the newsletters who are currently championing the call-writing strategy, however. They believe that, at a minimum, the stock market is heading into a period of above-average volatility -- if not a longer-term decline. They are recommending the approach because it enables you to avoid selling the shares you own while nevertheless increasing your income.
In effect, the strategy allows you to remain at Wall Street’s party for longer than you would otherwise.
The CBOE S&P 500 Buy/Write Index
To illustrate the correlation between the market and the performance of the call-writing strategy, consider the performance of the CBOE S&P 500 Buy/Write Index (INDEXCBOE: BXM), which the CBOE describes as “a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) ‘writing’ (or selling) the near-term S&P 500 Index ‘covered’ call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money).”
As you can see from the accompanying chart the BXM index lagged the S&P 500 during the go-go years of the 1990s. Then, in the wake of the bursting of the Internet bubble and the financial crisis, the BXM pulled ahead. During the incredible bull market of the past decade, however, the index has once again fallen well behind.
What can we conclude from this index’s long-term return? Based on the volatility of monthly returns since 1993, this index has been 27% less volatile than the S&P 500. So we should expect the index to also make less money than the S&P 500. But on a risk-adjusted basis it comes out slightly ahead.
The bottom line? A call-writing strategy is attractive enough to deserve your serious consideration. But, given the number of crucial details in the strategy’s execution, there are many ways in which the strategy can go wrong. Consult with a qualified professional, at least in the beginning stages, if you want to pursue the strategy.