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 stocks approach. In this regard, consider this investing wisdom from renowned investor 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 resources
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."
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 stocks strategy.
So what are our "edges" as Covered Calls investors? It is this advisor's belief that there are thirteen edges, each of which can contribute to our 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."
2. Active Management -- The typical Buy-and-Hold investing strategy is a passive investing approach since stocks, mutual funds, and ETFs 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 with approximately 30% less risk. 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 deploying the strategies itemized in the additional items enumerated in the remainder of this article.
3. Stock Selection -- Stocks are an appreciating asset over prolonged time periods and historically have achieved a higher return-on-investment than buying other asset classes (bonds, real estate, commodities, stock options, etc.). So, buying stocks should be the foundation of any long-term investing strategy, and buying stocks is fundamental to the Covered Calls strategy--where we buy stocks and sell Call options against the stocks we own. Identifying and buying good stocks is Job #1 for the Covered Calls investor. Unlike broad-based indices, such as the S&P 500 ETF (SPY) or other ETFs (such as the sector ETFs), we seek to purchase individual equities with good fundamentals which are likely to continue in the future, as they have historically, to outperform broad-based indices.
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 (1) our overall market outlook, and (2) our personal risk tolerance, incrementally higher return-on-investment results are achieved.
5. Exploiting the Volatility Risk Premium -- Academic research has demonstrated that the Implied Volatility of option prices is, on average, higher their subsequent actual realized volatility. So, 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.
6. 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 the overwhelming majority of individual stocks that comprise the index. Selling options on individual equities (with higher Implied Volatility than VIX) provides Covered Calls investors with 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).
In addition, we can benefit from the knowledge that the Implied Volatility of stock options have an inverse relationship with their short-term stock price performance. That is, Implied Volatility (and therefore also the annualized-return-on-investment (aroi) potential) decreases as a stock's price increases (and becomes overbought). Conversely, Implied Volatility increases when short-term stock prices decline and become oversold; and increasing Implied Volatility also provides increasing potential aroi -- so this is an opportune time to establish new Covered Calls positions, but of course only in companies we are bullish on (see item #3 on Stock Selection above).
7. Increase Frequency of Trading -- The time value decay of options increases the closer they get to their expiration date. So, shorter duration Covered Calls positions provide a higher potential annualized-return-on-investment than their longer duration counterparts. Favoring monthly, bi-weekly, or even weekly Covered Calls is preferable to positions of longer duration (two months, three months, or longer). An added benefit of shorter-dated options is that they provide more frequent opportunities to re-evaluate our holdings and to modify our ongoing strike prices given the ever-changing nature of market prices and individual stock outlooks.
8. Adjust Our Position Sizing -- We can use the Greek value of Delta as a good approximation of the probability of assignment of any Covered Calls position we are considering prior to entering the position. Delta values enable us also approximate an Expected Value for the Annualized Return-on-Investment potential for various stock price outcomes on the options expiration date (such as if the stock price is unchanged, or if the stock price ends in-the-money). This knowledge of various Expected Value Return-on-Investment outcomes helps us to determine the position sizing for the investment -- higher Expected Value Returns corresponding to larger-than-average total dollar positions and lower Expected Value Returns corresponding to below-average total dollar positions.
9. Seek to Minimize Losses -- Because our compounded return-on-investment results over time are geometric returns (not average returns), losses are difficult to overcome. For example, a 33 1/3% loss doesn't require a 33 1/3% gain to get back to breakeven; it requires a 50% gain (and a 50% loss would require a 100% gain). Covered Calls provide an advantage over the traditional buy-and-hold stocks in this regard since selling Call options against our stock holdings provides a hedge (i.e. lowers our stock downside breakeven price point) and therefore increases the likelihood that we will be profitable on our positions. Furthermore, when we are selecting a strike price for any position where we have doubt between two potential strikes, we can select the more conservative (i.e. lower) strike price to decrease our probability of losing money on the position, therefore further increasing our probability of achieving a profitable outcome.
10. Invest in Non-Correlated Assets -- Another way (in addition to that stated in #9 above) we can minimize drawdowns (i.e. losses) in our portfolio is to seek to diversify our portfolio via non-correlated assets. We know intuitively and from our own investing experience that different asset classes rotate in-and-out of favor and that it is extremely difficult to try to predict when these rotations will occur. But there is substantial academic research that has determined that investing in non-correlated assets (such as by asset classes, sectors, industries, geographies, etc.) enhances geometric returns. So, achieving adequate diversification via non-correlated assets in our portfolios is another important consideration.
11. Use a Tax-Advantaged IRA Account -- The great likelihood of triggering short-term capital gains makes
Covered Calls an ideal strategy for either Traditional and/or Roth
IRAs since these profits can be left in the IRA (tax-free) for additional future investments growth. Of course, any funds withdrawn from IRAs are subject to applicable tax laws in the year they are withdrawn.
12. Use a Dividend Capture Strategy When Appropriate -- Covered Calls investors can increase the annual dividend yield of quarterly dividend-paying companies by establishing Covered Calls positions during the single month each quarter when they go ex-dividend (and avoiding those same companies during the other two months each quarter when no dividend is paid). The Covered Calls Advisor's "Dividend Capture Strategy" worksheet (see details here) was designed to identify these opportunities that provide another "edge" to our financial results. These positions can be especially attractive to boost returns in low-growth and/or below average Implied Volatility sectors (like the Consumer Staples, Energy, Financials, Industrials, Materials, Real Estate, and Utilities sectors).
13. Avoid Earnings Reports -- I have learned (sometimes the hard way) that the stock price reaction on that day each quarter when a company issues their earnings report can frequently be extraordinarily unpredictable -- that is with very large stock price moves (sometimes very positive but also sometimes very negative). So, when considering potential companies to invest in, I always identify when their next earnings reporting date will be and I strongly recommend avoiding consideration of any company with an upcoming earnings report that is prior to the options expiration date.
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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 the thirteen "edges" described above, and works to take advantage of them might expect (on average over the years), to outperform a buy-and-hold benchmark (such as the S&P 500) by at least 3 to 5 percentage points on an annualized-return-on-investment basis. 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 these "edges" described above provides only a small advantage, together they can provide a very significant advantage for informed and disciplined Covered Calls investors.
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More detailed information on Covered Calls investing can be found on the author's free blog site, http://coveredcallsadvisor.blogspot.com/
