For any given investing strategy, the investor should be able to identify any and all discernible advantages that particular strategy has when compared against a basic stocks buy-and-hold approach. Once these potential advantages are identified, it is important to establish an investing process that attempts to fully exploit these advantages. The term that this Covered Calls Advisor prefers for these specific advantages is our investing
"edges". Identifying and then establishing an informed and 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.
Consider these related words of wisdom from two renowned investors:
- Seth Klarman:
"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."
- George Soros:
"Investors operate with limited funds and limited intelligence; they don't need to know everything. As long as they understand something better than others, they have an
edge."
So what are our
"edges" as Covered Calls investors? It is this advisor's belief that
there are six primary 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 approach in combination with the performance results achieved is what has sustained my commitment to Covered Calls investing during the past four decades -- thus this Covered Calls Advisor's investing motto of "Stick with Covered Calls."
Committing to a path of becoming a passionate, lifelong learner of Covered Calls investing will provide you an advantage that will
result in large profits in the years ahead. I hope you agree and decide to make Covered Calls the investing approach you
will focus on to achieve your clear investing "edge".
2. 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).
3. 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, incrementally better return results are achieved.
4. 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.
5. Sell Higher-Than-Average Volatility -- Because of the large-cap nature and the wide 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.
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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 and works to take advantage of the six "edges" described above can 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 while a Covered Calls investor averages a 12% annualized return. Then, an initial $100,000 portfolio would grow (if done in a tax-advantaged account such as an IRA) 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 a small advantage, deployed together they provide a very significant advantage to us Covered Calls investors.
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If you have any comments or questions on this article or anything related to Covered Calls investing, please email me partlow@cox.net. Your comments are always welcomed.
Regards and Godspeed,
Jeff
