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Thursday, January 17, 2008

A Rationale for Near-Month Covered Calls

It is readily apparent to regular readers of the Covered Calls Advisor that covered calls for the next closest expiration month (i.e. the 'near-month') are almost always selected for investment. 'Near-month' is the term used by this advisor. Synonymous terms used by others include one-month, front-month, and next-month -- and there are probably others. Any of these roughly equivalent terms is satisfactory to describe the concept of selling call options for the next closest expiration month in time. For example, after January 2008 options expire tomorrow, the near-month expiration becomes February 2008; After the Feb08 expiration date, Mar08 becomes the 'near-month' expiration; etc; etc.

This article provides an explanation of why this advisor prefers near-month covered calls rather than 2nd-month, 3rd-month, 4th-month, 12th-month, or any other time horizon.

Writing near-month covered calls almost exclusively was not this advisor's original intention. Initially, a preference for 'laddering' a portfolio was intended -- the term 'laddering' refers to a portfolio containing a variety of expiration months. For example, a portfolio of 10 stocks might have three near-month positions, two 2nd-month positions, two 3rd-month positions, two 6-month positions, and one 12-month position. One clear advantage of laddering is that only a portion of one's portfolio needs to be modified each month, whereas investing solely in near-month covered calls necessitates establishing new covered call positions on 100% of all equities in the portfolio. In addition, varying time horizons provides a desirable characteristic in that it offers some increase in a portfolio's overall diversification. Nevertheless, this advisor has concluded (until further evidence is obtained that demonstrates otherwise) that near-month covered calls provide an opportunity to obtain higher investment returns over time and thereby justifies the additional trading frequency.

Let's look at some data in this regard. Today, I searched out those companies in which:
1. The stock was trading exactly at a strike price. For example, Boeing closed yesterday at exactly $80.00 and there is an $80 strike price; and
2. Options existed for multiple expiration months with the option's current open interest exceeding 100 contracts -- this condition is to ensure sufficient options liquidity for a fair market value option bid price. For Boeing, the near-month (Feb08) open interest is 2,761 contracts; the 4th-month (May08) open interest is 4,067; and the 12th-month (Jan09) is 4,780.
Four companies met the above criteria: Agnico-Eagle Mines(AEM), Boeing Co(BA), PSS World Medical(PSSI), and Tibco Software(TIBX). Both the Annualized Return if Unchanged(ARIU) and the Downside Breakeven Protection(DBP) were calculated for near-month (Feb08 is now 30 days until expiration date), 4th-month (now 121 days to expiration), and 12th-month (now 366 days until expiration) for each of these companies. The results are:
AEM -- ARIU is 73.0% and DBP is 6.0% for near-month covered calls. ARIU is 36.7% and DBP is 12.2% for 4th-month covered calls. ARIU is 20.3% and DBP is 20.4% for 12th-month covered calls.
BA -- ARIU is 45.6% and DBP is 3.8% for near-month. 21.1% and 7.0% for 4th-month. 12.7% and 12.8% for 12th-month.
PSSI -- ARIU is 51.7% and DBP is 4.3% for near-month. 23.3% and 7.8% for 4th-month. 10.2% and 10.3% for 12th-month.
TIBX -- ARIU is 80.8% and DBP is 6.7% for near-month. 38.1% and 12.7% for 4th-month. 20.5% and 20.7% for 12th-month.

The overall average for the four companies is:
ARIU is 62.8% and DBP is 5.2% for near-month covered calls.
ARIU is 29.8% and DBP is 9.9% for 4th-month covered calls.
ARIU is 16.0% and DBP is 16.1% for 12th-month covered calls.

The Covered Calls Advisor contends that the covered calls investor is more likely to obtain a higher overall annualized rate of return through a persistent covered calls investing program using near-month expirations exclusively. However, what is right for one investor is not necessarily right for all. Those covered calls investors seeking greater downside breakeven protection than is normally available in near-month positions should rightfully select longer-term covered calls -- and that is perfectly acceptable for the more conservative investor.

The examples above provide a useful but very limited view since there are only four stocks analyzed and for only a single day in time. However, other more comprehensive studies have also concluded that near-month covered calls provide superior financial returns compared with any longer-term period. For example, a paper describing the results of one study of covered calls over a 15-year period (1990-2005) was presented in an article entitled "Finding Alpha Via Covered Index Writing" in the Financial Analysts Journal (Vol. 62; Number 5). One of the several interesting conclusions presented in the article was: "In all cases, the three-month call-selling strategies underperformed the strategies selling one-month S&P 500 options." Regardless of the time frame considered, other studies have invariably reached the same basic conclusion.

Additionally, it is more than coincidence that buy/write indicies (BXM and BXY for example) utilize only near-month covered calls in their index -- near-month strategies consistently provide higher long-term returns in comparison with any longer-term period. Consequently, using the higher-return strategy is useful when comparing return results of various buy/write strategies (note: the term 'buy/write' used in this case is synonymous with our use of the term 'covered calls') versus 'buy-and-hold' benchmarks such as the S&P 500 or the Russell 3000.

So what are you thinking now? Still not convinced about writing near-month covered calls? Why? Does it seem as if it would be too time-consuming to do the research and analysis in order to make so many portfolio changes every month? My answer to that is that "it's worth it". Consider another conclusion from the same study referenced above concerning the benefits of near-month covered calls: "Covered S&P 500 index call strategies have, on average, outperformed the S&P 500 Index over the past 15+ years while realizing lower standard deviations of returns."
Higher returns with lower risk! -- In a word, that's "sweet"!

Regards and Godspeed,

1 comment:

  1. 1st let me say thanks for sharing these wonderful ideas about CC investment. I have a questions, is the stock price also play an important roles for near month CC. Let say, the stocks price $15.00 and the strick $17.00 for the near month possible pay 11 - 15 cents. If the stock price at $50 then the strick $52.50 or $55.00 would pay about 40 - 50 cents depend on the IV. For someone like me which I don't have a whole lot of capital to invest in the high price stock, how do I play CC with stock range below $20.00. Any advise would be approciated.

    Thanks in advance,

    Steven Zhao