More Options on Covered Calls

Employing covered calls remains one of the most popular and basic options trading strategies, but also one of the most overused or misapplied.

Some newly launched funds can help individual investors introduce a slice of this conservative, but somewhat labor intensive, strategy into their long-term portfolio investment pie. (For a primer on covered calls, click here.)

In July, the ( MCN) Madison/Claymore Covered fund raised $260 million, and in August, ( FFA) First Trust/Fiduciary Asset Management Covered Call fund raised $338 million. Unlike some existing mutual funds that use options, these two are closed-end funds, meaning they will not be accepting new investors or even new money from existing investors. But one can buy (and sell) stakes in their publicly traded shares.

Both funds are benchmarked to the Chicago Board Options Exchange's (CBOE) BXM Buy Write Index (BXM). Last year, I wrote about the CBOE licensing its BXM Index to be named as both a benchmark and replicated by money management firms in an attempt to bring covered-call strategies to the masses and capitalize on investors' desire to stabilize returns and reduce risk after a five-year roller coaster ride.

The BXM Index is based on applying a purely mechanical buy-write program to the S&P 500 Index, in which 30-day at-the-money calls are sold against a long position in the underlying index. Click here for details on the construction and methodology of the BXM Index.

The bottom line is that over the past 15 years, the BXM has delivered a compounded annualized return of 12.39%, slightly better than the SPX's 12.20%, but with 34% less volatility or market risk.

The use of options to reduce portfolio risk and volatility, especially through covered-calls writing, received another boost last month when Chicago-based research firm Ibbotson Associates published a study on Passive Options Investment Strategies, with a particular focus on the buy-write strategy based on the BXM Index.

This study, combined with a growing acceptance of using options to manage risk and deliver more stable returns, helped the successful launch of the two new covered-call funds this past summer.

Closed Advantage

The advantage of a closed-end fund is that it does not need to adjust its position (expand due to inflows or sell because of redemptions) and therefore can maintain a more disciplined approach to a mandated covered-call strategy than an open-ended fund.

This is important because, unfortunately, professionals, just like individuals, often let emotion and short-term action lead them astray. This may come in the form of adjusting strikes and expirations or using puts to offset existing positions. Often, adjustments to an option position are done for defensive reasons and can convolute the initial investment thesis or objective. By trying to benchmark or adhere to the BXM Index, one can move toward eliminating the stock-picking and market-timing elements of investing, drives home the strengths and weaknesses of covered-call writing. It also should help clarify expectations and remove second-guessing.

But assembling a portfolio to match the S&P 500 and adjusting the number of calls needed to be sold as the value of the index fluctuates can lead to increased costs in the form of trading fees. That may be why Rampart Investment Management, the Chicago-based firm that received the first BXM licensing deal with the CBOE last year, initially marketed its BXM Strategy managed accounts to institutional investors such as pension funds, foundations and endowments. But with nearly $4 trillion in investments benchmarked to the S&P 500, it was inevitable that more accessible vehicles would be launched for public consumption.

Nearly all covered-call funds (or those that use put options for either income or protection) retain discretion for the fund manager to adjust the beta or net exposure of the position based on his outlook and the prevailing conditions. For example, Greg Drake, the portfolio manager for the Madison/Claymore fund, says he intends to sell calls against approximately 80% of the fund's holdings at any given time.

This means the funds contain an element of market-timing or specific stock selection, which can lead to either outperformance or underperformance over any given time period or particular trading environment. Despite low option premiums, the current environment of range-bound trading is well suited for using a buy-write strategy in a portion of your portfolio.

While there are some arguments to be made for having a professional handle the transactions, tracking and accounting, the BXM shows covered calls can effectively be used by anyone. Last month, I discussed using covered calls on core holdings as a means to secure profits or set price targets on particular stocks within a portfolio. But remember that this can be both labor-intensive, as it requires not only a considerable amount of time in selecting covered-call candidates but also maintaining and adjusting the positions. That, in turn, can lead to significant cost in the form of trading commissions and tax considerations. It would be a huge undertaking for an individual to replicate the BXM.

The recent launching of closed-end funds gives investors the ability to integrate the income, stability and reduced volatility of covered-call writing into their overall portfolio without incurring the monthly costs, in terms of both dollars and time, associated with maintaining an ongoing buy-write program in multiple names. Still, the above-mentioned funds do have higher costs than many traditional mutual funds; Madison Claymore charges an annual fee of 1% and First Trust's fee is 1.22% of assets under management.

And you can bet that the CBOE, though declining to officially comment, or some other financial firm such as Barclays or Standard & Poor's, would love to offer an exchange-traded fund-type product based on the BXM that would allow individuals to invest in a low-cost, one-stop covered-call program. Given the track record of the BXM and the universal success of ETFs, I think this type of product, if we see it, would prove a winner for both the issuer and investor.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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