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Friday, January 2, 2009

Stick With Covered Calls

One of the most important investing lessons I've learned is to select an investing strategy that you are most comfortable with and stay with it. That is, do not try to be "a jack-of-all-trades and a master of none." Instead, try to continually increase your knowledge related to the strategy you are using and seek to become an expert at it. This doesn't imply that we should become rigid and inflexible in the application of our methods. To the contrary, it is essential to be life-long learners and to apply new knowledge to continually refine our approach. This is the mindset I try to maintain as it applies to my preferred investing strategy, namely covered calls investing.

In my very first blog post on this Covered Calls Advisor blog site in 2007, I stated that the essential reason why I believe in covered calls investing is that "covered calls offer an excellent avenue for obtaining market-beating results while at the same time offering the added benefit of doing so with less overall portfolio risk." My intention is to demonstrate the truthfulness of this objective over the next several years.

First, let me affirm that I do believe in the generally accepted personal financial planning principle that we should maintain a money-market account with 3-6 months of living expenses as an emergency buffer. But once the emergency fund is fully funded, additional money available for wealth creation can be committed to our preferred investing method, covered calls investing.

But why not use additional investing strategies beyond just covered calls?
From time to time there is a tendency to want to augment covered calls investing with alternative investment strategies. Some of the alternatives that have some similarities to covered calls and that sometimes seem appealing include: (1) Buy-and-Hold Stock Investing; (2)Covered Calls With Collars; (3) Selling Calls against LEAPs; and (4) Selling Cash-Secured Puts. Below is a short explanation for each of these alternative strategies that explains why covered calls are preferable, at least as far as the Covered Calls Advisor is concerned.

1. Buy-and-Hold Stock Investing: There is some research which has simulated (back-tested) over a multi-year period the results that would have been obtained by investing in covered calls via a diversified index (such as the S&P 500) and by subsequently mechanically reinvesting each month in slightly out-of-the-money, near-month covered calls. The conclusions generally support the notion that the annualized return-on-investment results (when comparing buy-and-hold with the covered calls results) are virtually indistinguishable between the two investment approaches. However, the studies also show that covered calls have only about 70% of the risk of buy-and-hold investing. It is this advisor's contention that covered call returns can outpace those of buy-and-hold investing through astute stock and strike-price selections as well as from the timely rolling of existing covered call positions when appropriate.

2. Covered Calls With Collars: This strategy is simply a covered call in combination with the purchase of a put option. This strategy is popular with very conservative investors who purchase the put option as insurance against a significant decline in the price of the underlying stock. I have analyzed this strategy several times (especially during the 2008 bear market we've just experienced), but each time I come to the same conclusion -- the cost of buying the put option is just not worth the price we have to pay for the additional insurance. Note: I say 'additional insurance' since the call we sold to establish the covered calls position already provides some protection against a decline in the underlying stock price. The cost of buying a put option to achieve a second level of insurance is just too high a price to pay, especially if we are at all successful in our objective of selecting stocks that are neutral or bullish -- then we achieve significantly better overall returns over time with covered calls. Remember also that our objective as investors is to 'buy' assets that tend to appreciate in value over time (such as stocks) and to 'sell' assets that depreciate over time (which is the case with both put and call options because of their decay in time value). So we want to 'buy' stocks (appreciating asset) and 'sell' call options (depreciating asset) -- which is our covered calls strategy; but also not 'buy' a put option (depreciating asset).

3. Selling Calls Against LEAPs: A few years ago, this was a strategy I used for several months before returning to covered calls. This is an alluring strategy, but it is both a more risky and, over time, less profitable than covered calls. The reason(s) for this are not readily apparent, but the primary reason this is true is the same line of reasoning above for collars, namely we want to buy appreciating assets and sell depreciating assets. The decline of time value embedded in all options (including LEAPs -- even though they do decay more slowly) ultimately makes LEAPs a less desirable asset to buy than stocks (which of course have no time decay inherent in their purchase price).

4. Selling Cash-Secured Puts: This strategy is a synthetically equivalent strategy to covered calls so in theory one should be indifferent to using either approach. In that regard, there is some appeal to the notion that one should begin a position by selling a cash-secured put and then if the put is exercised you would then be obligated to purchase the stock at the agreed upon strike price. Then, since you now own the stock you would then simply keep the stock and sell a call option against it, thereby establishing a covered calls position. If this covered call is in-the-money on the expiration date and the stock is called away, then the natural course of action would be to then sell another cash-secured put. So the investor moves naturally to-and-fro using both covered calls and cash-secured puts as the results at each expiration unfold. This approach has some merit (when compared with using only covered calls or only cash-secured puts) in that it provides somewhat less trading friction (i.e. the costs of additional trading commissions and the pricing differences in bid-ask spreads). Nevertheless, I have opted to commit solely to covered calls investing in the interest of clarity and simplicity. Owning covered calls in your brokerage account makes it crystal clear at all times what the current cash balance in your account is. Not so with cash-secured puts since at any given time it is more difficult to distinguish between the total amount of cash that is commited to securing the put options and the cash that is truly available for use. In this regard, one is more likely to oversell puts and to then be in a position where we are forced to sell out of a position or to trade on margin (Note: the Covered Calls Advisor is strongly opposed to margin account investing).

The four alternatives to covered calls investing described above are certainly not intended to be a comprehensive list. But they do represent the types of strategies that have periodically been mentioned as possible alternatives to covered calls in various posts on the 'justcoveredcalls' Yahoo Group site.

Although the Covered Calls Advisor is uncommonly committed to covered calls investing, from time to time even I have flirted with other possible investing approaches. But there is a lot to be said for not over-complicating our investment decision-making processes. And the more strategies we are willing to use in our portfolio, the more complicated our investing becomes, and the more difficult it is to decide what strategy to use for what stock in what situation. And these complications just beget more confusion and second-guessing which can readily become psychologically debilitating. Committing to a single investing process (hopefully you'll agree that it should be covered calls), gives us a much better chance at achieving a characteristic shared by all great investors -- a calm, dispassionate big-picture perspective; and the possibility of enjoying the time we spend on our investing research and analysis.

As always I welcome your comments.

Regards and Godspeed to All,

Jeff

2 comments:

  1. Jeff, I enjoy your blog. Nice work. Have you read this article re: put writing? http://vixandmore.blogspot.com/2009/01/often-overlooked-put-writing-strategy.html

    Take care and good luck

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  2. Thanks for the lead to the article, but yes I have read it. In fact, I'm the Jeff that made the first comment you'll see if you look at the article via Seeking Alpha:
    http://tinyurl.com/6vmj3n

    ReplyDelete