Covered Calls and Risk
Throughout the tenure of this blog we have talked a lot about how Covered Calls affect the risk of a long stock position. Namely that it helps reduce the downside risk of a stock position by lowering the cost basis due to the Option's premium. Today we're going to take another look at how Covered Calls help reduce the risk of your covered stocks.
When we talk about reducing risk using Covered Calls it is how the premium from the Call affects your overall capital at risk. A technical way of displaying this is something called a Risk Curve. A Risk Curve, for our concerns, is simply a graph that helps display under what conditions an investment strategy is profitable, unprofitable, and breaks even. Drawing out a Risk Curve for your strategies can help conceptualize the different outcomes that can occur. Let's take a look at an example of a risk curve.
The above is a simple unlabeled Risk Curve. The horizontal axis represents the stock price at the expiration of the Call, while the vertical axis represents a relative payoff, or profit. The solid grey line represent the stock price. That is if you bought the stock, did not sell a Call on the stock, and did not sell the stock at the expiration date of the Option, your profit would be increase linearly with the increase in the stock price. In regular-person speak, this just means that for every $1 the stock price gained over what you paid for it, you would get a $1 profit. Simple.
The blue line is the result of selling JUST the Call option. Namely that when you sell the Call, your profit stays flat, until the price of the stock exceeds the strike price of the Call. Once that happens, you begin to take a loss, as you will end up having to go out and buy the stock at its current price, and then sell it at the now lesser strike price. This is why we do not recommend selling Naked Calls, as there is a large potential downside of having to go into the market and buy a stock that has exceeded your strike price.
When you put the add the stock results with the short Call results, you get a Covered Call Strategy, indicated by the grey dotted line on the graph. This line indicates that your profit is greater than holding the stock up until the point where the stock price rises to the strike price. If the stock price is above the strike price at expiration, your profit no longer increases as you must sell the stock away at the strike price. The black dotted line represents the profit of selling the stock without taking the premium into account.
This may seem like all old knowledge, but a few things can be gleamed from this Risk Curves. The first thing to look for is the gap between the grey dotted line, the Net with Premium, and the grey line, which is the profit profile for just the stock. By comparing Risk Curves of different strategies, you can get a visual indication of how profitable Calls with varying strike prices can end up being. When combined with intersection point of the two lines, one can get a better feeling as to which Call best balances the chances at increased profit due to the premium with the likelihood of missing out on profit due to stock price appreciating past the strike price. In addition, a more mathematical look at the area between the the two lines can give a measure of the relative profitability based on stock price variance (this is generally a bit much). The last piece of important information is by regressing the grey dotted line down to the horizontal axis, which gives you your break even point; the price the stock much be at to have a profit of $0.
There is one risk to the Covered Call strategy that is indicated by this graph - namely that your profits plateau after the stock price appreciates beyond the strike price. This is generally the largest criticism of the Covered Call strategy in general. Luckily, there is some data that helps support the use of the strategy
The BXY is a CBOE Index that buys the S&P 500 index, and every month sells the next month's 2% out-of-the-money Call on the index. Essentially, it is a Covered Call strategy for the entirety of the S&P 500. The above graph shows the 20-year performance of $1 in each of the indexes, and you will see that for the most part, the BXY stays above the S&P 500, and ends up over 14% higher at the end of the time span.
Here we have additional data for the BXY as compared to the S&P 500. On the left are the annualized returns of the indexes, where we see the BXY outperforms the S&P 500 by 0.7% over twenty years. But the right graph is what we are really concerned about. This shows that the writing Calls has decreased the standard deviation on your long investment by 2.3%. A lower standard deviation indicates lower risk due to smaller reactions and price changes. These are just a few more examples of how risk is reduced using the Covered Call strategy.