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Tuesday, December 1, 2015

Exploiting Our Covered Calls Investing "Edges"

Below is a reprint of an article I wrote for this blog over 5 years ago. I believe the concepts discussed continue to be as valid today as they were then.

For any given investing strategy, the investor should try to identify any and all discernible advantages that particular strategy has when compared against a basic buy-and-hold approach. Once these potential advantages are identified, it is important to establish an investing process that attempts to exploit these advantages. The term that this Covered Calls Advisor prefers for the specific advantages identified is our investing "edges". Identifying and then establishing a disciplined investing process to exploit these "edges" is what enables us to attain additional profit beyond that which would otherwise be obtained through a passive buy-and-hold strategy.

So what are our "edges" as covered calls investors? It is this advisor's belief that there are six edges, each of which provides an opportunity to achieve excess returns:

1. Specialize in Covered Calls Investing -- Here is the introduction to one of my prior blog posts: "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 fundamental belief in combination with the performance results achieved is what has sustained my commitment to covered calls investing during the past three decades -- thus this Covered Calls Advisor's investing motto of "Stick with Covered Calls."
I was recently reminded of my uncommon commitment to covered calls (and the investing edge it provides) while reading this article: (See "7 Things To Do To Improve"). Charles Kirk concludes in item #7 titled "Become a specialist, not a jack of all trades", by saying "So, find something that interests you more than anything else and concentrate all of your time and focus on that one thing. That path will lead you to developing a clear edge that will provide huge profits to you down the line." I hope you agree with me and will consider making covered calls investing "that one thing" you will "focus on" to achieve a "clear edge".

2. Active Management -- The typical buy-and-hold investing strategy is a passive investing approach since stocks or mutual funds are normally purchased and held for a period of years. Likewise, covered calls investing can also be deployed passively, and passive covered-calls-related indices (for example BXM, BXY, and PUT) have been developed. Research has shown that the long-term returns performance of these indices are approximately equivalent to that of a comparable buy-and-hold investment. But as individual investors, we have the opportunity to be "active" (contrasted with "passive") managers of our covered calls portfolios. As active managers, an associated "edge" comes from making timely adjustments (for example, position rolling decisions) related to our existing covered calls positions.

3. Value-Oriented Stock Selection -- Good stock selection is Job #1 for the covered calls investor. Unlike broad-based indices such as the S&P 500 or BXM, we seek to purchase only value-oriented individual equities, which are likely to continue in the future (as they have historically), to outperform the broader indices (such as the S&P 500).

4. Adjust Moneyness of Strike Prices -- As active covered calls investors, we have the flexibility to sell out-of-the-money covered calls when our outlook is more bullish and in-the-money when bearish; whereas the mechanical indices sell the same moneyness every month (for example, only at-the-money calls in the case of BXM). With even modest success at adjusting moneyness to coincide with our overall market outlook, incremental return results are achieved.

5. Sell Higher-Than-Average Volatility -- Because of the large cap nature and the diversification inherent in the S&P 500 index, its Volatility Index(VIX) is lower than most individual stocks. Selling options on individual equities (with somewhat higher implied volatility than VIX) provides covered calls investors with somewhat higher options income (and thus somewhat higher overall portfolio returns) than would be achieved by either (1) buy-and-hold investing directly in the S&P 500; or (2) selling S&P 500 options (such as is done with the BXM, BXY, and PUT indices).

6. Exploiting the Volatility Risk Premium -- Academic research has demonstrated that the implied volatility of option prices is, on average, higher than the actual realized volatility. Thus, by selling options to establish our covered calls positions (NOT buying options), we covered calls investors exploit this effect (another "edge" versus buy-and-hold investors) and profit from it.

From my experience, my best estimate is that over a long-term investing horizon (say 10+ years), a disciplined covered calls investor that is cognizant of the six "edges" described above, and works to take advantage of them might expect (on average over the years), to outperform a buy-and-hold benchmark by about 3% to 5% per year. This extra return might not sound especially impressive, but the power of compounding investment returns is substantial. Suppose that over the next decade a buy-and-hold S&P 500 investor averages an 8% annualized return; and a covered calls investor averages a 12% return. Then, an initial $100,000 portfolio would grow (excluding taxes) over the next 10 years, to about $215,900 for a buy-and-hold portfolio; but to $310,600 for the covered calls portfolio. Whereas individually, each of the six "edges" described above provides only a small advantage, together they can provide a very significant advantage for covered calls investors.
"We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What's your edge? To succeed in today's overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resource provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work." -- Seth Klarman

If you have any comments or questions on this article or on any of the six "edges" presented, please email me at the address shown in the top-right sidebar of this blog. Your comments are always welcomed.

Regards and Godspeed,