How Managed Asset Portfolios Utilizes Covered Calls
Nov 13, 2024Thanks to favorable market conditions led by advancing technologies, the stock market has been defined by strong returns over the past several years. Over the same period, volatility surges have also come to define the market, as stocks trading at historically high valuations are increasingly sensitive to negative stock market developments. These heightened volatility levels have increased the popularity of derivatives trading, which simply put, allows investors to hedge risks, or to place leveraged bets. As an active money manager, it is our responsibility to find prudent ways to generate alpha1 while reducing risk. Although volatile markets can make that task more difficult, they provide the opportunity to write covered calls.2 This piece explores how Managed Asset Portfolios (MAP) utilizes covered calls and the criteria we set within our strategy.
A covered call strategy can allow investors to experience capital appreciation through stock ownership, while adding capital gains by writing call options against the shares owned (in totality or partiality). It can also be an effective way to exit a position if the stock is approaching a stated target price. As an example, an investor would own 100 shares of stock XYZ while simultaneously or subsequently selling (or writing) a call option on their position. The investor collects any dividends and price appreciation from the stock while collecting a premium from writing the call options. If the stock price stays below the call options’ strike price, the investor gains from the call option value going to zero while either adding or subtracting any returns of the stock position itself. If the stock price reaches or exceeds the call options’ strike price at or before expiration, the investor may have their stock position “called away” to cover the call option on the stock, and any dividends will no longer be collected after the sale. While writing covered calls can reduce downside risk, the writer of a covered call foregoes the opportunity to benefit from an increase in the value of the underlying interest above the option price. Figure 1 above illustrates this, where the “Long Stock” represents the payoff if there is no call option written, and the red/green vector represents the covered call strategy.
MAP has a non-systematic approach to covered calls, which does not mandate a minimum amount of call writing. This strategy gives us the flexibility to participate in ‘risk on’ market environments in a more meaningful and opportunistic way. MAP also views covered call writing as a way to reduce overall portfolio volatility by affecting the distribution of returns, which has been a key to achieving durable risk-adjusted returns. This active, opportunistic approach to covered call writing helps prevent falling into a trap of being caught with underperforming stocks while the winners get called away.
Said another way, MAP writes calls under at least one of two conditions: 1) volatility is heightened, and we see an opportunity to give us a favorable risk/reward; or 2) a stock is approaching its target price, and we view that writing a call at that target price is a way to gain a little extra alpha while exiting a position.
To paint a fuller picture, when we analyze volatility, we look at historical trends and the events surrounding any abnormalities. The discussion below outlines an example of the historical volatility of First Solar,3 a solar panel manufacturer based in the United States.
Although First Solar is one of the more volatile stocks in the market, it is important to highlight the points where writing calls could be beneficial (green annotations). The reasons that volatility was heightened, and call premiums were seemingly attractive are noted. The low point in the graph represents where call premiums would have been too small for MAP to consider writing a covered call against the stock and the red circle in August 2024 represents the volatility caused by the Yen Carry Trade unwinding. Although the heightened volatility in August shows that call premiums would be higher, it could be unwise to write calls considering the markets were expected to rise relatively swiftly following the event (which they did).
MAP does not simply write calls because volatility is high. We take a multi-pronged approach that considers all factors and events before we decide to enter a covered call position. There are several elements that establish the price or premium of an option, including volatility, where higher volatility raises the option’s premium and vice versa for lower volatility. That premium is what determines the stand-still rate of return on a covered call. Annualized stand-still rate of return is the annualized return an investor receives on the option if the stock price is the same at expiration as of the day the call is written. It is important to consider the return an investor receives, as the risk to the trade is the sacrifice of potential gains if the stock moves past the strike price. MAP generally does not consider annualized returns of 3-4% as sufficient, but once those returns get to the high single digits/double digits, and our assessment of volatility is favorable, the trade starts to pique our interest. MAP takes a vigilant approach by measuring the rate of return against the potential the stock appreciates rapidly (volatility is a good proxy for this). Doing so prioritizes risk-adjusted returns, a vital piece to a durable active portfolio.
While options writing may not fit the risk and return objectives of every investor, MAP believes that covered calls are a prudent way to generate alpha while reducing portfolio volatility in an actively managed portfolio. If you have questions or want to learn more about MAP’s options writing strategy, please reach out to your MAP sales representative.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, Zachary Fellows, John Dalton, and Nicolas Vilotti
November 13, 2024
1Alpha is a financial metric that measures how well an investment performs relative to a benchmark or market index. 2Call options are a type of financial derivative that gives the owner the right to buy 100 shares of a stock for every option owned (as one call contract represents 100 shares) at a certain strike price within a specific time period. The seller, or writer of the option, receives a premium, or payment in return. 3Managed Asset Portfolios does not own shares of this security. This does not represent a recommendation by us to buy or sell this security or any other financial instrument associated with it. It is provided as a representation of our investment process. We are not obligated to provide an update if any of the figures or views presented change.
Clients must be approved for writing covered call options. For more information regarding options, please see the Options Disclosure Document titled “Characteristics and Risks of Trading Standardized Options” published by the Options Clearing Corporation, June 2024. Certain statements made by us may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. The information contained herein represents our views as of the aforementioned date and does not represent a recommendation by us to buy or sell this security or any other financial instrument associated with it. Managed Asset Portfolios, our clients and our employees may buy, sell, or hold any or all of the securities mentioned. We are not obligated to provide an update if any of the figures or views presented change.
