LEVATUS Q & A | The Market Is Not Going Up! What Can I Do? | Covered Call Writing Strategy
The power of taking control, especially in a down market, is huge. Leveraging this power is at the heart of our most recent series, ‘The Market Is Not Going Up! What Can I do?’. First topic, Covered Call Writing.
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A thoughtful approach to volatile markets should go beyond just buying, selling, or ‘holding on for dear life’. An approach that increases control can not only add value, it can also help investors to lean into the long term perspective that is so essential to investment success.
Our view is that pressure on markets and volatility are likely to persist for the next one to two years. In situations like these, it can feel like there is almost no way to avoid declining portfolio values. In some ways this is true, periodic drawdowns in equity markets are a part of normal economic cycles, with volatility the price one pays for long term rates of return that are above the risk-free rate. There are, however, strategies that leverage the volatility in these types of markets to investors’ advantage.
In our new series, The Market Is Not Going Up! What Can I Do?, we will highlight some of the ways we are helping our clients to take control in a down market. The first topic we will feature is Covered Call Writing. This is a strategy that is useful under many market conditions, but particularly when volatility is high. It is a strategy that in essence, monetizes volatility.
What is a Covered Call?
Covered call writing is a strategy that takes advantage of extreme price volatility and can earn investors income on existing stock positions. When an investor ‘sells a call’ on a stock position, they enter a contract whereby they agree to sell that stock at a certain price, the ‘strike price’. The contract is good for a set period, typically one to three months.
The power of this strategy is in the amount of money the investor is paid for selling this option. The higher the market volatility is, the more the investor selling the call is paid. What the investor risks is that stock prices will go up and they will not earn as much as they might have by just owning the stock position because it can be purchased at the agreed upon strike price. Bottom line, this is a good strategy to capture value in a highly volatile market environment when there is downward pressure on stocks. Check out the example below for a real-life dollar and cents example.
Why is now a good time to implement this strategy?
Significant market volatility has been caused by inflation and the associated rise in interest rates as well as the unwinding of the historically unprecedented liquidity measures implemented by the US Federal Reserve and other Central Banks. What this means in real terms is that there is less money to buy stocks and Central Bank policy is now attempting to slow down economic activity rather than pump it up. On-going supply chain issues and the war in Ukraine contribute to the inflation pressure. While it may be a challenging time for the stock positions in equity portfolios, a way to turn this volatility into an opportunity is to add some option premium on existing stock positions though covered call writing.
Because the investor selling the call already owns the stock, covered call writing is considered a less aggressive option strategy than some others. There is, however, still price risk involved. The investor pockets the dollars (‘premium’) when the option is sold but potentially limits the upside potential if the stock price goes above the strike price within the agreed upon time frame. If the stock price declines or stays the same, the investor maintains ownership of the stock and pockets the premium. While the ups and downs in the stock price are not eliminated, the investor is grabbing the value offered by the high option premiums available during volatile market conditions.
I sold a call, now what?
Once you have sold a covered call and collected the premium, there are three potential outcomes you can expect:
Expiration: When a call expires, it means that the owner of the contract (i.e. the person that paid for the ability to buy the shares from you at a certain price.), decided not to exercise their option. The primary reason why someone would not exercise an option is because the stock price never went above the strike price. For example, if you sold a call of ABC Company at a $100 strike price, but the stock was only at $90, it would expire unexercised because the owner of the contract could buy the shares on the open market for less. As a result, you, the seller of the option, would keep both your shares of the stock and the income you received from selling the option. You are free to go ahead and sell another call if you would like.
Exercise: When a call is exercised, it means that the owner of the contract has decided to execute their ability to buy your stock from you at the previously agreed upon price. In the above example, it means that the price of ABC Company is over $100 so it is less expensive to execute the option than buying in the market. If your option is exercised then you will still keep the premium you received when you sold it in addition to the proceeds from the sale of the stock, but you no longer own the shares of stock.
Buy it back: Sometimes you may want to buy a call back before the expiration date. You would do this in a situation where the price of buying it back has drastically decreased so you are still gaining from the money paid to you for selling the option, but you have decided you do not want to sell the underlying stock position. If you buy back the call, you can then re-write the same position for a later date.
Can you show me an example of how a covered call works?
Let’s imagine you currently own 500 shares of Apple (APPL) which is trading at a market price of $133.50. If you sell 5 August $135 APPL calls at a price of $8.70, you will bring in $4,350 of option income.
1 option = 100 shares of stock
5 Apple options = 500 shares of APPL stock
500 shares of APPL Stock * $8.70 Option price = $4,350 of option income
By collecting this premium, you are agreeing to sell your 500 shares of Apple for $67,500 (500*$135) before August. If the stock price goes to $150 and the buyer exercises the option, the option seller will no longer own the APPL shares but will receive the $67,500 from the APPL proceeds in addition to the $4,350 of option premium.
If the stock price goes down to $125, the option will expire and you will still own the 500 shares of APPL having brought in the option premium to enhance return.
What can I expect at tax time from this strategy?
Covered call writing is a particularly good strategy to use in tax sheltered accounts like IRAs, as the dollars earned from premium frequently fall into the short-term capital gains category. This tax rate is not a factor in tax sheltered accounts but can create a relatively high tax burden in taxable accounts. Some instances where the short-term rate applies include:
· If a call is not exercised - the cash received by the seller of the option is considered a short-term capital gain regardless of the length of time the option was open.
· If a covered call is closed with a closing purchase transaction, the net capital gain or loss is considered short term regardless of the length of time that the option was open.
· If a covered call is assigned (meaning the owner of the option decides to buy the stock at the agreed upon price), the strike price plus the premium received becomes the sale price of the stock in determining gain or loss. The resulting gain or loss depends upon the holding period and the basis of the underlying stock.
How does covered call writing compare to a strategy like short selling?
We generally prefer the combination of cash and some covered call writing over short selling. Covered call writing takes advantage of higher volatility (premiums paid go up with higher volatility), and the cash gives you some dry powder to get great entry points as the market swings around.
Short selling is in general a much riskier strategy as there is no way to be certain at what prices you will be able to buy back the stock should prices surge, so your potential loss is theoretically unlimited. Also, because interest rates and volatility have gone up the cost of borrowing stock to be able to sell it short is quite high. This means a short seller would be in the hole quite a bit before they start. With covered call writing an investor would be on the other side of that, getting paid the high premium due to higher volatility and higher interest rates.
While the covered call writing strategy is not for everybody, it is a strategy worth speaking with your advisor about. It provides another tool in the toolkit during these extreme market conditions.
The information provided is for informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Views and opinions are subject to change at any time based on market and other conditions. Any projections, market outlooks, or estimates in this presentation are forward looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Levatus LLC is a registered investment advisor. Levatus provides investment advisory and related services for clients nationally. Levatus will maintain all applicable registration and licenses.
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ABOUT THE AUTHOR
Susan Dahl is a seasoned executive, female leader and dedicated client advisor with over twenty-five years of international and domestic investment experience. Susan writes on topics such as long term investment growth and where to find it, the power of female leadership, and the intersection of investment and tax strategy. She is known for her work on investment process design for private wealth clients, as well as her development of a research based approach to financial advisory service delivery; an innovative approach that addresses quality of life in specific and tangible ways. A deep and diverse background that extends from global investing to risk management to process development and planning, has laid the groundwork for an advisory solution that asks more of wealth. She shares some her most recent work in a talk for TEDx, Can Happy Make You Money?
ABOUT THE AUTHOR
Keith Savard has more than 40 years of economic/finance research and investment experience in the United States and overseas. He has worked as a staff member at the Board of Governors of the Federal Reserve System and as an international economist at the U.S. Department of State. A solid background in macroeconomic analysis and financial regulatory and monetary policy issues, combined with sovereign and credit risk skills, has enabled Keith to offer investors actionable top-down investment strategies and expertise facilitating a broad-range of asset allocation decisions. His deep knowledge and understanding of emerging markets, gained through extensive travel and meetings with cabinet-level officials, company CEOs and local investors, affords opportunities to invest confidently beyond the United States.
August 2024 started with a swift drawdown in markets. As with many such corrections, a major contributor was leverage.