This article appeared in the September 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
New research shows the power of the buy-write strategy to boost income.
By Tony Rumble, BetaShares
Investors are aware of the benefit of earning a "risk premium" on returns they receive from shares compared to other asset classes. But whether such a premium does in fact exist is a sensitive point for many investors.
One concern is that if no equity risk premium is earned on their shares, it may be the case that returns from less risky assets such as bonds and cash deposits will be unable to build retirement wealth of the level needed by most Australians.
With that in mind, wouldn't it be good if you could get "paid" for the potential upside on your share portfolio, even when share prices stay flat? Such benefits are available from the investment strategy known as "covered call" writing (also known as "buy-writing").
Adding income to a share portfolio
The idea behind "covered call" writing is that you can sell a call option over a share that you already own (or are buying as part of the strategy) and receive a payment (the option "premium") from the option buyer. The payment received is for giving the buyer the right to acquire the share at a preset price at some future time.
With the call option in place, you can be forced to sell that share at the preset price should the price rise to that level. If the call option is exercised, you will make a profit on the share; and if it's not exercised, you will have received the option premium with no impact on your underlying shareholding.
The option premium you can receive can be looked at in two ways: either as a way of enhancing the yield on the shares (combined with dividends, option premium can potentially boost share yields substantially); or as a way to lower the effective cost of the share (think of the option premium as "subsidising" the cost of the share).
The core idea is that the covered call strategy is a way of pre-selling some of the future potential capital gain on the shares, which can be thought of as creating an equity risk premium return, even when the market is not delivering that via share price growth.
In light of increased scrutiny over investment strategies and products, it is critical for investors to understand the risks and returns of the covered-call strategy. A landmark research paper released in August by ASX validates the improvement in share returns from covered call investing. The ASX-commissioned research (summarised in Figure 1 below) plugs in actual data for 30 blue chips before and after the GFC and shows that between 20 and 60 per cent was added to basic share returns between April 2005 and December 2011.
Figure 1: How different investment strategies fared
Source: ASX Limited, "An Encyclopaedia of Buy-Write Returns (April 2005 to December 2011)".
See the report's executive summary for more detail on this chart.
The ASX research was conducted by one of Australia's premier number crunchers, SIRCA, an independent financial research body and collaboration between a number of Australia's top universities.
The basic approach assessed by SIRCA used a simple strategy of selling ASX exchange-traded options (ETOs) with a term or maturity date of one month, and with an exercise price that was 5 per cent (or as close as possible) above the share price at the time the call option was sold.
Because the strategy is based on the investor also holding the same number of shares over which they sell the call options, the strategy is fully hedged, therefore known as "covered call" writing (compared to not holding the same number of shares - or holding none at all - which is far riskier and is known as "naked" call selling).
The risks involved
In the case of covered call writing, the investor's risks include:
- The share price falls. But because the investor will generate cash by selling the call options and receiving the option premium, the downside risk is less when covered calls are sold than it would be if the shares were held outright.
- The share price rises by more than the strike price of the call option (in which case the buyer of the call option will exercise it and be able to buy the share for a price that is less than the then prevailing market price.
- Actual returns may be affected by market volatility and liquidity.
In this brief review we look at two of the covered call strategies the ASX paper analyses: the "basic" (shown in the red line in the chart above) and the "delta" (shown in the gold line). More detail around the other strategies is contained in the paper itself.
These two strategies deal with some of the practical concerns investors will experience when implementing a covered call approach.
For example, the paper analyses different methods of dealing with the problem in a rising market, where the sale of the call option will give the holder the opportunity to force you to sell your shares at a profit, but still below the price at which they are trading when the option is exercised. This means you have capped the upside on the stock - perhaps something to be avoided by active management of the call option.
Managing the covered call strategy
The simplest way to avoid losing the shares when a call option is exercised (which leads to them being "called away") is to buy back the call option position. To close out a sold call option position you simply have to buy an equivalent position; that is the same strike and maturity call as you have previously sold. To prevent having to dip into your pocket to buy back the (now more expensive) sold call option, it is normal to sell another call option (with a higher strike price and/or a longer maturity date) to fund the transaction.
Enter the ASX research, which considers the outcome of a number of different ways of managing the close out and resale of new call options. In fact, the "basic" strategy simply allows the call option to be exercised (if the share price has risen enough) or to lapse.
The ASX research shows that this is not such a bad approach. In the survey there were many periods where the shares did not rise through the call option strike price, meaning that even the "basic" approach performed better than simply holding the shares themselves. The "basic" approach shows a total of 20 per cent outperformance over the performance of the shares themselves during the 2005 to 2011 period.
Using "delta" to manage the call option position
The "delta" strategy uses specific rules to manage the option position. Using a simple option pricing calculator to determine the "delta" of the sold call option, it is possible to set a trigger level to govern the "close out" of the sold call option.
In the ASX research, the "delta" strategy triggered a buyback of the sold call option when its "delta" rose to the level of 0.85 during the option term. The delta approach added a total of 60 per cent to the performance of the shares themselves over the 2005 to 2011 period.
Delta is a concept that measures the degree to which an option tracks the underlying share performance: a delta of 0 means the option does not provide any exposure or correlation to movements in price of the underlying asset to which it relates; and a delta of 1 means the option and asset prices move by the same amount.
So in the ASX survey, if the share price rises and starts to approach the call option exercise price, this will produce a rising delta for the option. In the ASX research on delta strategy, if the share price rises and the delta of the call option rises to 0.85, the originally sold call option is bought back, and another call option is sold to fund the buyback.
In the delta strategy, the new sold call option also matures on the same date as the original call option, but the new call has an exercise price as close to 5 per cent above the (then prevailing) share price as possible.
What it means for investors
Interested investors can use the ASX paper as the basis for their own trading strategies, noting of course the general risks of sharemarket investing (although as noted above, consider covered call writing as a way of subsidising share investing).
As always, take advice if you are unsure of any aspect of covered call writing. ETOs are the most liquid and readily available options over ASX listed shares - and are backed by a central clearing house and the experience of the ASX options market (the second oldest option market in the world).
A wide range of support materials is available via the ASX website - lending support for a do-it-yourself option investor. Beware of paying high brokerage to transact options, as this will erode overall returns.
As the ASX research shows, covered call writing tends to work best when the market is flat and trends sideways. If you expect this to be the pattern for the sharemarket for a while, selling covered call options may be a savvy way to monetise the will o' the wisp that we know as the equity risk premium.
About the author
Tony Rumble, PhD, is head of portfolio construction, BetaShares. Twitter: @TonyRumble
The free online ASX options course is designed to help investors understand the features, benefits and risks of exchange-traded options, and introduce various options strategies - all in a stimulating, interactive learning environment.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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