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Covered calls - less than meets the eye?

msf
edited August 25 in Fund Discussions
Covered calls are something that intuitively sound good. Also, they're one of the few things about options that my father taught me, and parents always know best (unless you're a teenager:-)).

But they may not work well as long term investments. If you write covered calls that never get exercised, they boost returns (let's say, 1%/year) while not reducing volatility. That's because if you shift your entire performance line up by 1% it's still got the same jiggles, just 1% higher.

Actual volatility is reduced by lopping off peaks when the market jumps and the calls are exercised. That's the exact opposite of the way you want to reduce volatility. Think Sortino ratio, that measures downside volatility only.

And those lost returns from lopping off peaks? They cost a lot more than the relatively small income stream one gets from writing the calls. Here's a graph from Finominal showing how this strategy loses in a rising market. And markets tend to rise over the long term.
image
Writing calls does generate a certain income stream, which many investors look for. Though as the writer of the article accompanying the graph says:
Any investor can create income by simply selling a small stake of their portfolio, which is also favorable from a taxation perspective as capital gains tend to have lower tax rates than income.
https://caia.org/blog/2024/02/24/covered-call-strategies-uncovered

That's a sentiment I agree with and why I focus more on total return than divs with bond funds. YMMV.

Comments

  • edited August 25
    From the article,
    "In years where stocks declined, eg the global financial crisis in 2008 or the bear market in 2022, the call options expired worthless but did provide investors with additional income that reduced the drawdowns*."

    *(YBB Note) By tiny amounts. Basically, covered calls didn't provide downside protection unless some puts were bought using the covered call income.
  • I was being magnanimous, assuming constant income from writing calls regardless of market conditions.
  • edited August 25
    Most growth stocks
    AMD
    SMCI
    NVDA
    AAPL
    TSLA
    ARM
    MSFT
    AVGO
    And retails stocks TGT WMT CAVA

    SPY IWM qqqq also


    Delta 7-10% wklies cover calls contracts are usually free $
    Prem usually [+ ~0.25% ]
    Aapl move extremely slow you can do maybe little higher deltas like 12 13%..most folks I know do delta 14 15% w
  • edited August 27
    It doesn't surprise me. Over the years, there have been many ways to try to beat a simple index such as VOO/VTI/QQQ, but can't do it over the long term. The beauty of it is the fact that it is based on the market, AKA the price. The price is what buyers are willing to pay regardless of someone's opinion, including valuation.
    I have seen so many of these "special" funds fail again and again.
    Remember, the price is the ultimate indicator = KISS and total returns is what matters because it includes everything.
  • From the article,
    "In years where stocks declined, eg the global financial crisis in 2008 or the bear market in 2022, the call options expired worthless but did provide investors with additional income that reduced the drawdowns*."

    *(YBB Note) By tiny amounts. Basically, covered calls didn't provide downside protection unless some puts were bought using the covered call income.

    I will do this on positions with large gains that I wish to protect (ideally a zero-cost 'collar'), such as large dividend payers. I don't do it very often, but it can work well in that scenario. But CCs alone are rarely worth doing unless it's on a stock that doesn't really move very much -- which also means the premium you might get for the call makes it more trouble than it's worth.
  • Despite the recent flood of criticism, I've been using 2 covered call funds for a number of years and feel they serve their function quite well within my portfolio. I do prefer funds which write calls to a nominal portion of the portfolio. DIVO (a Great Owl) and QQQX offer a 4.46 and 6.79% distribution respectively, which I do not reinvest.
  • edited August 28
    PRESSmUP said:

    Despite the recent flood of criticism, I've been using 2 covered call funds for a number of years and feel they serve their function quite well within my portfolio. I do prefer funds which write calls to a nominal portion of the portfolio. DIVO (a Great Owl) and QQQX offer a 4.46 and 6.79% distribution respectively, which I do not reinvest.

    I am not against covered call strategies when done right, though I never own any. I had looked at DIVO in a discussion with @WABAC and liked it.

    If you are OK disclosing, what function do these funds serve within your portfolio?

    Why do you own the covered call strategy on QQQ in a CEF? In your experience, what portion (in a range) of the portfolio does the manager write the calls on?

    My questions are out of curiosity.

  • PRESSmUP said:

    Despite the recent flood of criticism, I've been using 2 covered call funds for a number of years and feel they serve their function quite well within my portfolio. I do prefer funds which write calls to a nominal portion of the portfolio. DIVO (a Great Owl) and QQQX offer a 4.46 and 6.79% distribution respectively, which I do not reinvest.

    The criticism is interesting considering some of the other things that are popular, and touted, around here.
  • You can buy QDTE XDTE passive approaches
  • @BaluBalu
    BaluBalu said:



    If you are OK disclosing, what function do these funds serve within your portfolio?

    Why do you own the covered call strategy on QQQ in a CEF? In your experience, what portion (in a range) of the portfolio does the manager write the calls on?

    Simply put, I use both items simply as contributors to fully fund my annual spending via their distributions.

    Why a CEF? I've owned QQQX for several years, and frankly, option overlays in an ETF wrapper weren't widely available at the time. There may be better options available currently, but this works for me and I'm comfortable with its longer track record and balance between distributions/asset growth.

    As for portfolio coverage, Nuveen states: "During the quarter, the core
    option overwrite level varied between 41% and 66% of the equity portfolio's value with an average level of 56%". Their option strategy is discussed in the attached link, which I found interesting.

    https://documents.nuveen.com/Documents/Nuveen/Default.aspx?uniqueId=378e5e6a-448d-49f8-b723-f56fc1f5876c

  • edited August 29
    Posters familiar with options know what they are doing.

    But my concerns are the investors who have poor/no knowledge of options but are buying options-based funds thinking that they are all-weather income funds.

    Call-writing (-selling or -shorting) funds are a bull market phenomenon. They turn capital gains (CGs) into options income, but don't protect the downside. They have grown like weeds in this bull market due to lots of marketing hype.

    Moreover, the traditional application of call-writing uses boring but steadily growing (mature?) stocks that don't move around much. So, investors holding those boring stocks can write calls and boost income some with the call premiums. Call-writing on volatile things like QQQ, on the other hand, is nontraditional and counts on rising markets that trigger written calls again and again to transform possible LT-CGs into ST options income. You may want to hold these in tax-deferred/free accounts.

    It isn't as if JPM has found some secret sauce for JEPI (AUM $34.8 billion, inception May 2020) and JEPQ (AUM $15.7 billion, inception May 2022). Granddaddy of options-based fund is GATEX / GTEYX that has been around since December 1977 (soon after options started trading in the US) and in those 46+ years, it has gathered an AUM of $6.6 billion. FWIW, it never impressed me much. Gateway is now a neglected part of French Natixis that also owns some more visible boutiques - Oakmark/Harris, Loomis Sayles.

    Natixis https://www.im.natixis.com/en-us/home
  • But my concerns are the investors who have poor/no knowledge of options but are buying options-based funds thinking that they are all-weather income funds.

    Exactly. I've mentioned risk profiles in a few other posts. There's been little response but that doesn't mean that everyone is familiar with them. Here's the risk profile of a covered call and and the risk profile of a pure long position overlayed. These are two of the simplest risk profiles you can have.
    image

    This shows a current stock price of about 39 and a strike price of 40. You do get about $1 worth of "insurance" if the stock price falls. But that's little consolation if the price drops $3 (left side of the graph). And you get a little extra profit in the middle if the stock doesn't rise past the strike price.

    But all the profit you might have gotten with larger price gains (right side of graph) is lopped off. That's a big price to pay for a cash stream if you're not carefully curating your call writing as Yogi described.

    Anything other than a pure long position alters (distorts?) the risk profile and makes metrics like standard deviation suspect. In part simply because you're no longer dealing with a normal distribution of outcomes and in part because the risk may be all bunched into low probability (but very bad) events that aren't reflected in the aggregate numbers (haven't happened recently).

    I took a quick look at DIVO. Nice fund, because the manager carefully selects and watches over the securities for which he writes calls. At the end of the day this (like all trading, I suppose) constitutes a form of timing. Quoting Yogi again, there's no "secret sauce".

    Since the selloff in March 2020, DIVO has run neck and neck with solid straight equity income funds: passive, like VYM and NOBL; and active like VEIRX.
    Portfolio Visualizer comparison

    This is not to put down DIVO. It has done remarkably well and looks to be a fund well worth considering. And it significantly outperformed in March 2020 (despite offering just "small" insurance).


  • edited August 29
    Good post @msf.
  • WABAC said:

    PRESSmUP said:

    Despite the recent flood of criticism, I've been using 2 covered call funds for a number of years and feel they serve their function quite well within my portfolio. I do prefer funds which write calls to a nominal portion of the portfolio. DIVO (a Great Owl) and QQQX offer a 4.46 and 6.79% distribution respectively, which I do not reinvest.

    The criticism is interesting considering some of the other things that are popular, and touted, around here.
    Well, everyone has to do what they’re comfortable with. If I would show my top 5 holdings, folks here would think I’m nuts.
  • PRESSmUP said:

    WABAC said:

    PRESSmUP said:

    Despite the recent flood of criticism, I've been using 2 covered call funds for a number of years and feel they serve their function quite well within my portfolio. I do prefer funds which write calls to a nominal portion of the portfolio. DIVO (a Great Owl) and QQQX offer a 4.46 and 6.79% distribution respectively, which I do not reinvest.

    The criticism is interesting considering some of the other things that are popular, and touted, around here.
    Well, everyone has to do what they’re comfortable with. If I would show my top 5 holdings, folks here would think I’m nuts.
    :)
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