Mention a strategy that involves selling options to an average investor and the conversation may end right there. Option writing strategies are often associated with complicated, high risk, lose-it-all speculation.
Yet one strategy that involves the writing of options is rather conservative: Covered call writing, which essentially means the stock underlying an option sold to the market is already owned, or “covered,” by the investor selling the call. Covered calls are used by many long/short equity hedge funds as a way to reduce the magnitude of losses while simultaneously participating in a portion of a stock’s upside. And although they are relatively unheralded and often misunderstood, covered calls can be a fantastic way to generate positive risk-adjusted returns through various market environments, all with a lower risk profile than the overall market.
To understand how institutional managers utilize covered call strategies, Modern Trader caught up with veteran options specialist Hugh Lamle, president of value-oriented alternative investment company MD Sass and an early advocate of covered call writing in conservative investment portfolios. MD Sass and its affiliated companies manage approximately $7.4 billion in relative value, long/short equity, fixed income, alternative and mutual fund strategies for a diverse group of institutional investors and high-net worth individuals, and offer covered call writing thought its Equity Income Plus strategy.
“The central logic behind covered calls is the willingness to cede some of a stock’s upside in return for generating cash flow and hedging against cataclysmic loss,” explains Lamle, who has been involved with options since 1969. “We own a carefully researched and selected equity portfolio comprised of companies with strong balance sheets, above-average dividends, low betas and for which our research team has established a price target. Then we write (sell) call options on those stocks, earning both the call premiums and the dividend yield until such time as the calls expire or the stock is called away.”
In this manner, the conservative nature of the strategy becomes apparent. “We’re earning 100% of the call option premium we’re paid when we write the call,” Lamle adds. “This mitigates potential stock price declines and adds substantial cash flow in normal markets, but we sacrifice some upside in strong markets.”The call premiums essentially lower the firm’s purchase price on a stock, which affords some downside protection, but the portfolio as a whole is also hedged through the use of equity index puts (see “Breaking down returns,” right). “It’s like being in the insurance business,” Lamle says. “We own a stock and we’re selling insurance on it to others. When we sell a call, we’re being paid a premium to take the risk of the underlying stock, just like your insurance company is paid a fee for insuring your car. The option premium we collect is the cost of that insurance. Then we’re reinsuring that risk across the whole portfolio with the index puts.”
Looking at the table you can see that the options tenc to lower overall returns in positve years, but increase overall returns in negative years or years where a large correction occurs.
MD Sass writes calls based on the target price the company’s analysts have established for the stocks it owns, based on a proprietary system that combines future earnings, dividends, P/E ratio, discount rates, future cash flows, etc., into a present fair value estimate. How far out they go depends on the stock. “If there is some catalyst we see that could drive a lot of upside, or a lot of volatility in the stock, we’ll sell more longer-term and out-of-the-money calls to capture the higher premiums,” Lamle says. “If not, we’ll sell shorter term and look to roll, and if the combination of strike price plus premium gets us to our target, we’re happy to be called away.”
As with any options strategy, volatility is a key element of the calculation. “If the implied volatility is high, we try to capture the additional premium associated with it and will go out six to nine months. If not, we’ll keep it short. Volatility is essentially mean-reverting, so we know spikes in either direction will eventually dissipate. While we want to capture premium when it is high, we don’t want to lock ourselves in when it is low.”
Lamle cites the insurance example again when describing how his firm uses volatility. “If you have a bad driving record, you’re going to pay higher premiums for auto insurance because you mathematically represent a higher chance the insurance company will have to pay out for a claim. The same is true for a volatile stock — risk is higher, and thus we get paid more premium for writing calls.”
Taxes also play a role. “We want to get long-term gains when we can, so we also look to structure expirations accordingly,” Lamle says. “If the option exercised when the stock is a long-term holding, the premium is considered long-term gain. We do this on a per-position basis, but managing for taxes is part of our thinking.”
MD Sass manages about $150 million directly in the Equity Income Plus strategy, which is also available as a liquid alternative mutual fund under the symbol MDEIX and was recently awarded four stars by Morningstar. Additional assets participate through separately managed accounts primarily sourced through RIAs, which is where the tax-managed aspect often plays a role.
“Everyone is looking for yield,” Lamle observes, “So to the extent you are generating 8% to 10% in call premiums and 2% to 3% in dividend yields from strong companies, and you can layer some capital appreciation in as well, it becomes an attractive proposition.” Moreover, the mutual fund pays out all income and all realized capital gains, which investors can choose to automatically reinvest.
Given the fund’s emphasis on downside protection, we couldn’t help but ask how well the strategy fared during the turbulence following Britain’s decision to leave the European Union in late June.
“The addition of index put coverage is specifically designed to hedge macro risks like Brexit,” Lamle answers. “The portfolio is protected through both call option premiums collected and dividends, but if you’re surprised by a negative event, there are event-driven gains in the put options purchased to protect the whole portfolio. This works on two levels — the puts gain in value because equity indexes have dropped, but volatility increases their value as well.
The Equity Income team, managed by executive vice president Ari Sass, felt going into Brexit that any sharp decline would be temporary, so they didn’t change anything in the portfolio. It was a prescient decision. “We did use the decline to realize profits in some of our index puts,” Lamle says. “We use them to hedge, but it was a double whammy as the index dropped and volatility literally exploded. The degree of protection varies by volatility, so we used the spike to close some gains in the puts that were available to us.
“For us, Brexit actually worked out fine and the portfolio performed exactly as expected,” Lamle says. “We were down about half of the broader market’s movement in the portfolio, but gained around 75% of the subsequent recovery.”
Lamle credits the simplicity of the strategy for the steadiness. “A lot of strategies that exhibit high or low correlation during routine markets fall apart when things go to the extremes,” he says.
“When markets become dislocated, you don’t know what will happen in the short run, what will be liquid, etc.,” he points out. “So it doesn’t makes sense to hedge risk with instruments that seem uncorrelated. To hedge equity portfolios via something not tied directly to what you own is a bet that those correlations and relationships that looked great on paper will remain intact in extreme environments. That’s a dicey proposition when you’re talking about hedging risk, and the reason we hedge equity market risk with equity index puts.”