In The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad and the Ugly, author Larry Swedroe questions claims that covered calls are less risky (when risk is measured by the standard deviation of returns) than long-only portfolios. He points out that in a covered call strategy, the distribution of returns is not “normal” and that standard measures such as the Sharpe ratio are not very useful in measuring risk.

Classifying covered calls a “flawed” alternative investment, Mr. Swedroe notes that the strategy has two undesirable traits: (1) The returns exhibit negative skewness (Skewness is a measure of the asymmetry of a distribution) and (2) The strategy eliminates the potential for a highly positive return while having no impact on the potential for an extremely negative return (Kurtosis risk).

Mr. Swedroe concludes:

While covered-call strategies appear to promise “a free lunch” of increased returns with less risk, investors who care about more than the volatility of returns will not find this an efficient strategy.

This article has 19 comments

  1. Few investors really understand what the technical financial people mean by risk. Both upside and downside surprises count as risk. As Swedroe points out, covered calls reduce upside volatility without changing the downside. You get the premium as compensation, but big downside surprises are still possible. This doesn’t line up well with the typical person’s notion of reduced risk.

  2. Is he saying that the distribution of returns for long equity investments is normal (matching a bell curve) then?

  3. @Michael – I’d say writing covered calls will reduce the downside risk, but not by very much. And definitely not by as much as what you can lose on the upside. :)

  4. What about using a full collar strategy? Limit downside with puts.

    Are you aware of any study of the systematic use of equity collars? If you find the right stocks/options combo, you may be able to largely offset the options themselves, limit downside, but have potential for some upside.

    I’m guessing the combo of ‘sure bets’ is few and far between but they probably do exist.

  5. @Michael: To add to your comment, covered call sellers highlight the lower SD of the strategy as an advantage over long-only. I suspected that capping the upside was one reason why SD for the strategy is low. It’s good to see that it is the case.

    @Value Indexer: I think Larry’s point is that SD is one measure of risk but it is inappropriate for covered calls. I believe he does recognize that stock market returns have much more fat tails than one would find in a normal distribution.

    @Mike: I have an upcoming post on returns covered call ETFs have provided in the US compared to benchmarks. Some of these ETFs have been around for 5 years.

    @Sampson: I haven’t looked into equity collars. I thumb though Mark Wolfinger’s book every now and then. I’ll check if he refers to any studies in his book.

  6. @Mike: When you say that “covered calls will reduce the downside risk, but not very much”, this can only be in the non-technical sense of risk. By collecting a premium you will end up with a little more money if the stock tanks. In this sense the risk is a little lower. However, in the technical sense risk refers to volatility. Once you collect the premium, it has no volatility. So, the downside risk (in the technical sense) is exactly the same for going long and writing covered calls. If I had my way we’d stop using the word “risk” in this technical sense.

    All this quibbling over definitions matters little compared to the loss of upside, as you said.

  7. @CC
    I’m glad someone is finally diving into this topic with some depth, instead of just describing what these ETFs are. I’m looking forward to seeing the results from your comparison to these ETFs in the U.S. and the benchmarks. Though the big institutional investors and pension funds do use Covered Calls from what I have read.

    It would be nice if you cover the Canadian ones as well such as ZWB and HEX – a lot of people are touting these as safe investments. I am not an expert by any means in this area, but I see 4 issues with these products:

    1. They are actively managed
    2. They have higher returns – therefore there has to be higher risk. There is no free lunch with returns.
    3. They don’t hedge against declines in markets (as many people believe) and may be more volatile
    4. There will likely be a loss in upside potential

  8. @Michael: So “risk” enters my list of words (like “correction”) whose common-sense meaning differs markedly from the technical definition.

    Perhaps “variability” has the right connotation? For instance, it’s clear that the premium you collect in a covered call strategy does not reduce the strategy’s “variability”.

  9. @Patrick: I prefer “standard deviation”. If you’re going to talk about a mathematical concept, then you might as well use the mathematical name. At least then it will be clear to most readers that they don’t understand what the writer means. Using the word “risk” just gives people the illusion that they understand, which is bad writing in my opinion.

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  11. @Patrick, @Michael: Are you talking about confidence? Using multiple variabilities (sigma in your terms @Michael) we can measure confidence too. (as inverse of risk).
    Where I always get confused is the the amount of uncertainties these models produces – which may render the result difficult to trust.

  12. @Sudip: Do you mean confidence intervals? If so, the usual method of applying confidence intervals does not apply very well to covered-call strategies. This is because the distribution gets skewed. In effect, the interval to the downside is wide and the interval to the upside is narrow. This is bad news for investors who worry about losing money.

  13. There is unlimited upside potential in my opinion! If I buy 100 shares for $50 and write a $55 call option people will argue that if the stock goes up to 60 or 70 I lose out. NO! What if I buy another 100 shares when the stock hits my strike price of $55 and I now do not lose the upside potential. Plus I might as well write another call option for some more income.

    • @Josh: That won’t really work, will it? If the stock hits $55 and you purchase another 100 shares, it means you have $5,500 lying around just for this possibility. And what if the stock then slides back to $50 before option expiry? You now own 200 shares and have a loss of $500 compared to the previous month. Or consider what happens when the stock now rises to $60 before the first option expires. What would you do? Purchase another 100 shares?

  14. @Josh: That works only if the stock reaches $55 as the option expires. Where will you get the money to buy new shares if you have to wait until the option expires to get your $55 per share? Your choices are to have ready cash to deploy which has a cost, buy back the call option, or wait for the option to expire when the shares might be more expensive to rebuy. All of these amount to loss of upside from selling the call.

  15. Josh is partially correct. HXT, for example, does not get called, they instead buy back the option and eat the loss. The long portfolio remains intact and any large upside is still captured. They miss out on upside due to the option loss, not due to being out the position (due to a call).

    Not that I’m advocating it. Properly done, a covered call strategy should in the long run net zero, minus costs. Better off with a low cost passive etf. IMHO.

  16. @Michael: For your second method, wouldn’t it be possible to buy back the call (very little time value) at a loss, sell a higher strike OTM covered call option (lots of time value)? Would selling another call help compensate for any loss on the buy close of the covered call and help the investor hold on to the underlying?

  17. @Internalaudit: If you buy back the call when the underlying reaches $55, it’s time value is statistically equal to the expectation of the underlying’s upside. Sometimes the time value will be less than the eventual upside, but if the underlying actually holds at $55 or goes down, you’ll give up more in time value than the (nonexistent) eventual upside. None of this changes the fact that the upside was given up at the moment the call was sold.

    @Brad: I agree with your final conclusion, but the first part is mental accounting. If one part of your portfolio gets the upside, but another part has lost a corresponding amount, what have you gained?

  18. I run a similar fund personally to the HEX, only it based on the FTSE UK shares. You must not forget that there is a third dimension to a covered call strategy that consistently outperforms a long only strategy.
    This element is the sale of time, which by definition, is always successful and gives the constant over performance over any strategy not involving the sale of time.
    Whatever happens to the underlying you will always have that “built in” profit. Yes you will lose out occasionally on the odd share that rises quickly, and stays high, but overall you will win.
    Taking examples previously mentioned, buying a share at $50 and writing the $55 call option, if the worst! happens and the share goes to $60 then there is every chance that the share will come down a little so I would buy back the $55 option near expiry and resell the $55 option at a further date. You would find that there would still be a time element in the resale and you would hardly be any worse off. Your “loss” would be $5 on the share price itself, but the sale of the time element would probably bring in about $4 so it is not all bad news. If the share comes back to $55 you have “lost” nothing and the full sale of time remains yours.
    If you are happy to hold the Canadian index as a shareholding, this strategy is massively superior, even if the index goes down. The sale of time makes sure of that.
    Of course if you think the Canadian index will double very quickly, i.e. in a couple of months, this strategy will flounder to some extent, but it will still make a profit!.

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