Covered calls
Sep. 25th, 2024 02:30 pm![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
ny_quantPrevious part is here.
Covered call is the opposite of naked call where you can lose a theoretically unlimited amount if you sell the option and the underlying stock goes up into stratosphere. The covered call strategy, aka buy-write, involves a long position in the stock and a short call on the same underlying.
I am going to assume that everyone has some savings in stocks. Without loss of generality, I’ll talk about a stock XYZ that currently trades at $500, but you can think of SPY on May 1st. Suppose, you own 100 shares of XYZ ($50,000 investment) and you sell one contract (100 options) of 2% OTM calls (strike 510) expiring in 1 month for $2.50 each. Thus, you received $250 in option premium or 0.5% cash addition to your account. I am ignoring taxes, compounding, dividends and commissions now for clarity.
Let’s consider what can happen.
Case 1. The option expires OTM before the stock price reaches 510. In this case you just earned extra 0.5% and live goes on. You hold on to your stock and sell another contract of 2% OTM options expiring in a month.
Case 2. The option expires ITM and gets exercised at or before the maturity. You are forced to sell your stock for $510. Thus, your account now has $51,250 in cash. In this case, you buy 100 new shares (you might need some extra
cash) and sell another contract of 2% OTM options expiring in a month.
The strategy is to maintain a long position in the stock/ETF (that’s the buy-and-hold strategy that you learned to love) + a series of monthly OTM calls to generate additional income. In summary, the investor keeps first 2% of monthly gains and gives away gains in excess of 2% in exchange for steady income stream at the rate 6% (12*0.5%) per year. What are pros and cons? First, note that I chose the 2% OTM strike for this illustration for a couple reason, (even though there are many ways to skin this cat, e.g. sell the strike that yields the desired price, e.g. 0.75% of the underlying, or trade weekly or quarterly):
(1) S&P 500 grows at the rate of 8% or so in the long term, it’s about 2/3% in an average month, so, heuristically I think it’s a good idea to keep 3 times the average return while returns >2% are not very frequent (we’ll look at the data later), so it’s better to have a guaranteed 6% per year income.
(2) I actually saw a study where it is shown that systematic use of the 2% OTM monthly covered calls beats investing in SPX index by a good margin. Unfortunately, I lost the web link so I can’t tell you by how much exactly. It’s a well-known web site.
Best case scenario: every month returns under 2% so you earned 6%/year in addition to the stock/index return; if the index lost more than 6% then you still lost money but much less. Of course, there is a lot of volatility in monthly returns, so it will never be quite like this, but you get the idea.
Worst case scenario: each monthly return was >2%, let’s say 3% on average. Ignoring compounding you could have earned 36% return in that spectacular year, instead you earned 30% = 12*(2%+0.5%). You underperformed the index by 6% but still made a lot of money. There won’t be many such years.
Below is a snapshot of my live trading screen from Fidelity. I show 4 options with strikes spaced by $5. You can see how the call prices are decreasing with strike. You can also see the bid/ask spread for SPY is very narrow – 1 or 2 cents only. Oct-25 is a “minor” expiration (the major ones are on 3rd Friday of the month) so the strike 581 (closest to 2% OTM) is not trading yet but you can interpolate to see that it should be around $3.60 or about 0.63% of the underlying price. So, 6% per year in the example above was a conservative estimate, in reality it’d be over 7% annual income for the SPY covered call strategy.
Now, let’s revisit the choices of strike and maturity. Making the “optimal” choices is the art of this strategy. You can simply do what I described above or consider the fact the distribution of future returns is not stationary. It depends on the current state of the market and its shape varies wildly. I am not going to tell you a lot of trade secrets, but being a nice guy that I am, I’ll show below you one chart that I made specifically for this presentation. The top panel shows unconditional (i.e. using all data in my spreadsheet) distribution of monthly returns of SPY. The bottom panel is only for the days when SPY is within 2% from the top. As you see, the distributions are markedly different. For example, generally, the probability of >5% monthly return is 13% but if SPY is near the top then it is only 2%. The market generally doesn’t know or care about it but you should. Why is this important? Because by choosing the strike you find a compromise between the premium that you receive and the gain on your stock that you will give up. Let’s say 5% OTM call trades at 0.1% of the underlying, as in the picture above. If you do it 100 times then you gained 10% additional return on your capital. Two of these 100 months the returns were 6%, so you gave away only 2% of potential returns, and 8% you get to keep. We conclude that selling 5% OTM strikes when SPY is near the top is a profitable strategy on average. But maybe not the best possible. You need to work with data to optimize it. I am just giving you the framework how you might want to think about it.
The last point is about choice of maturity. Option prices (near ATM) scale like square root of time to maturity, so 1 year option costs only x2 of 3-month option and about x7.5 of a 1-week option which you can sell 52 times per year. Also, remember that due to supply-demand dynamics, options are typically overpriced, so when you sell options you are overpaid. It makes sense to be overpaid more often. I am not allowed to trade short-maturities options by my employer, so I didn’t research the optimal strategies yet, but most of you could so you can try to figure out optimal strikes by yourself. Trading short maturities requires more attention and the results won’t be sweet as I implied but there is some extra juice there.
It is important to note that the covered call strategy is more conservative, not just more profitable, than the traditional buy-and-hold. This is because by writing calls against your long stock position you narrow the distribution of future returns, i.e. the worst returns become a little less bad, and the best returns become less good. The latter is the part of the trade-off – there are no miracles.
Questions? Let me know if you read it and everything is clear. Comment is better, like is good enough.
Covered call is the opposite of naked call where you can lose a theoretically unlimited amount if you sell the option and the underlying stock goes up into stratosphere. The covered call strategy, aka buy-write, involves a long position in the stock and a short call on the same underlying.
I am going to assume that everyone has some savings in stocks. Without loss of generality, I’ll talk about a stock XYZ that currently trades at $500, but you can think of SPY on May 1st. Suppose, you own 100 shares of XYZ ($50,000 investment) and you sell one contract (100 options) of 2% OTM calls (strike 510) expiring in 1 month for $2.50 each. Thus, you received $250 in option premium or 0.5% cash addition to your account. I am ignoring taxes, compounding, dividends and commissions now for clarity.
Let’s consider what can happen.
Case 1. The option expires OTM before the stock price reaches 510. In this case you just earned extra 0.5% and live goes on. You hold on to your stock and sell another contract of 2% OTM options expiring in a month.
Case 2. The option expires ITM and gets exercised at or before the maturity. You are forced to sell your stock for $510. Thus, your account now has $51,250 in cash. In this case, you buy 100 new shares (you might need some extra
cash) and sell another contract of 2% OTM options expiring in a month.
The strategy is to maintain a long position in the stock/ETF (that’s the buy-and-hold strategy that you learned to love) + a series of monthly OTM calls to generate additional income. In summary, the investor keeps first 2% of monthly gains and gives away gains in excess of 2% in exchange for steady income stream at the rate 6% (12*0.5%) per year. What are pros and cons? First, note that I chose the 2% OTM strike for this illustration for a couple reason, (even though there are many ways to skin this cat, e.g. sell the strike that yields the desired price, e.g. 0.75% of the underlying, or trade weekly or quarterly):
(1) S&P 500 grows at the rate of 8% or so in the long term, it’s about 2/3% in an average month, so, heuristically I think it’s a good idea to keep 3 times the average return while returns >2% are not very frequent (we’ll look at the data later), so it’s better to have a guaranteed 6% per year income.
(2) I actually saw a study where it is shown that systematic use of the 2% OTM monthly covered calls beats investing in SPX index by a good margin. Unfortunately, I lost the web link so I can’t tell you by how much exactly. It’s a well-known web site.
Best case scenario: every month returns under 2% so you earned 6%/year in addition to the stock/index return; if the index lost more than 6% then you still lost money but much less. Of course, there is a lot of volatility in monthly returns, so it will never be quite like this, but you get the idea.
Worst case scenario: each monthly return was >2%, let’s say 3% on average. Ignoring compounding you could have earned 36% return in that spectacular year, instead you earned 30% = 12*(2%+0.5%). You underperformed the index by 6% but still made a lot of money. There won’t be many such years.
Below is a snapshot of my live trading screen from Fidelity. I show 4 options with strikes spaced by $5. You can see how the call prices are decreasing with strike. You can also see the bid/ask spread for SPY is very narrow – 1 or 2 cents only. Oct-25 is a “minor” expiration (the major ones are on 3rd Friday of the month) so the strike 581 (closest to 2% OTM) is not trading yet but you can interpolate to see that it should be around $3.60 or about 0.63% of the underlying price. So, 6% per year in the example above was a conservative estimate, in reality it’d be over 7% annual income for the SPY covered call strategy.
Now, let’s revisit the choices of strike and maturity. Making the “optimal” choices is the art of this strategy. You can simply do what I described above or consider the fact the distribution of future returns is not stationary. It depends on the current state of the market and its shape varies wildly. I am not going to tell you a lot of trade secrets, but being a nice guy that I am, I’ll show below you one chart that I made specifically for this presentation. The top panel shows unconditional (i.e. using all data in my spreadsheet) distribution of monthly returns of SPY. The bottom panel is only for the days when SPY is within 2% from the top. As you see, the distributions are markedly different. For example, generally, the probability of >5% monthly return is 13% but if SPY is near the top then it is only 2%. The market generally doesn’t know or care about it but you should. Why is this important? Because by choosing the strike you find a compromise between the premium that you receive and the gain on your stock that you will give up. Let’s say 5% OTM call trades at 0.1% of the underlying, as in the picture above. If you do it 100 times then you gained 10% additional return on your capital. Two of these 100 months the returns were 6%, so you gave away only 2% of potential returns, and 8% you get to keep. We conclude that selling 5% OTM strikes when SPY is near the top is a profitable strategy on average. But maybe not the best possible. You need to work with data to optimize it. I am just giving you the framework how you might want to think about it.
The last point is about choice of maturity. Option prices (near ATM) scale like square root of time to maturity, so 1 year option costs only x2 of 3-month option and about x7.5 of a 1-week option which you can sell 52 times per year. Also, remember that due to supply-demand dynamics, options are typically overpriced, so when you sell options you are overpaid. It makes sense to be overpaid more often. I am not allowed to trade short-maturities options by my employer, so I didn’t research the optimal strategies yet, but most of you could so you can try to figure out optimal strikes by yourself. Trading short maturities requires more attention and the results won’t be sweet as I implied but there is some extra juice there.
It is important to note that the covered call strategy is more conservative, not just more profitable, than the traditional buy-and-hold. This is because by writing calls against your long stock position you narrow the distribution of future returns, i.e. the worst returns become a little less bad, and the best returns become less good. The latter is the part of the trade-off – there are no miracles.
Questions? Let me know if you read it and everything is clear. Comment is better, like is good enough.
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no subject
Date: 2024-09-26 11:10 pm (UTC)Попытаюсь узнать, какие у нас ограничения на такое и какие комиссионные. На покупку акций / ETF, похоже, в районе £12 за сделку, насчёт опций не уверен.
no subject
Date: 2024-09-27 02:13 pm (UTC)no subject
Date: 2024-09-27 07:28 pm (UTC)On the cost of trading this info is not very clear yet
Looking at one of the larger brokers, ig, it seems they charge $1 per option contract, max $10 per leg. https://www.ig.com/usermanagement/customeragreements?igCompany=iggb&agreementType=costs_and_charges&productCode=TASTYOPT&locale=en_GB
Plus clearing fee of $0.1 plus a couple of other similarly low fees.
A separate section for SPX and the like, SPX is charged at $0.65
0.5% USD conversion fee - can probably be avoided if using FX brokers, but no idea how it works when pension money is involved.
We have 2 schemes here, one is SIPP, self-invested pension, this seems to allow Options trading.
The other is ISA, tax-free saving account, but you put post-tax money in it :-) These don't allow options - it's a pity.
My problem is my pension contribution goes into employer-provided scheme (as they pay their own part) and it doesn't seem to matter which funds I choose, the total doesn't grow much :-) Putting money into my own SIPP account will be a hassle - but I am now sure it's worth it due to at a minimum a greater flexibility and lower charges.
no subject
Date: 2024-09-27 08:10 pm (UTC)Same here with the pension contribution. But this is not my first place of employment. Here, old pension savings can be rolled over to brokerage accounts that allow options trading, among other things.
no subject
Date: 2024-09-27 10:07 pm (UTC)I am not sure 0.5% is necessarily a problem as my understanding (hope?) is GBP gets converted to USD once and then all US activities will be using the dollar account. Certainly needs checking.
Unfortunately, my pension contributions before joining the current company were tiny (buying a house was a major priority), so the best I can do is redirect part of the new money I save into a new pension account. It is weird that both pension and standard broker account allow options, but ISAs don't : logically pension savings should be guarded more. But why search for logic...