Treating option premiums from covered-call strategies as income overestimates long-run spending power.
These days, income is the name of the game. A slew of covered-call mutual funds have emerged recently, advertising their option-selling strategies as ways to enhance the dividend income from an equity portfolio. Investors are often seduced by this idea, believing that the premium generated by covered calls is "free money" to spend on daily living needs, particularly in retirement. Investors who fall victim to this fallacy, however, may unwittingly be depleting their principal nest egg.
To understand why covered-call strategies are not sustainable income strategies, one must first understand the ins and outs of covered calls. A covered call is the simultaneous purchase of common stock and the sale of a call option on the same stock or index. If the underlying asset's price falls below the strike price of the option at expiration, the investor keeps the money he or she received for selling the option. If the underlying asset's price is above the strike of the option, the asset is called away, and the investor is paid the strike price. Thus, when the option expires, the covered-call position is worth, at most, the strike price of the option, plus the amount of premium received for the option. But it could be worth much less. The stock or index price could end up far below the strike price of the call option at expiration, meaning the investor has lost money (even after adding back the call premium received). It is this potential for loss of principal that makes a covered-call strategy a poor substitute for a retirement income strategy.
Depicting a covered call graphically can help add some intuition. Exhibit 1 shows how an investor who owns a stock is exposed to both the red downside and the green upside of the stock price. A covered-call investor sells the upside for a cash payment, leaving only downside exposure. (Cash-secured short put options work the same way.)
Source: Morningstar Analysts.
Some investors also believe that, besides generating income, a covered-call strategy is useful for exiting a fully valued or overvalued stock position; they sell the call option in order to generate current income, and they don't mind if the underlying stock is called away. Such a belief reflects a lack of understanding of the covered call's risk profile, however. A covered call is a bullish strategy that an investor should use when he or she expects the position to rise in value to the strike price or, at the very least, to not decline below the strike price. If one believes a stock is fully valued or overvalued, a better decision is to sell the stock and look for another undervalued investment opportunity.
The Fallacy of Option Income
In theory, if stocks only rose and never fell, covered-call strategies could be fantastic income strategies. But in practice, the downside is frequently realized. When an investor sells an at-the-money covered call and spends all of the premium income, the "principal" is only safe when the underlying stock or index has risen at expiration. If the underlying stock or index has fallen, the covered-call portfolio value effectively "ratchets down," because a new call option will be sold on the lower-priced asset that prevents any value recapture when the asset rebounds. This problem compounds when there are frequent or dramatic drawdowns.
Exhibit 2 below illustrates the problem with viewing covered calls as income. The exhibit shows the growth of $10,000 invested in both the S&P 500 Total Return and S&P 500 Price Return Indexes, as well as the CBOE S&P 500 BuyWrite Index (BXM)--a strategy that sells at-the-money call options on the S&P 500 every month and reinvests the premium--between June 2004 and April 2010 (the period of available data from the CBOE). It also shows a theoretical portfolio, labeled BXM Ex-Call Premium, in which the call-option premium is removed from the portfolio each month as if an investor were spending the income.
The S&P 500 Total Return and CBOE S&P 500 BuyWrite generate similar levels of return, and the covered-call strategy reduces the magnitude of the peaks and valleys in the S&P 500 returns. The value of the S&P 500 Price Return declines relative to the S&P 500 Total Return as the dividends are spent rather than reinvested in the portfolio. However, the BXM Ex-Call Premium strategy clearly illustrates the ratcheting-down effect of spending the entire option premium. The portfolio value declined by 72% during this time period because the return of capital prevented the BXM Ex-Call Premium strategy from capturing the upside of the market when it recovered from the market bottom in early 2009, whereas the CBOE S&P 500 BuyWrite Index increased 19.2%.
Income vs. Total Return
In fact, the very concept of an income-producing security is a fallacy. A dollar of return is a dollar of return, whether that return comes from capital gains, coupons, dividends, or option premium. Christine Benz, Morningstar's director of personal finance, strongly advocates total-return strategies as opposed to income strategies and discusses here how to set up a retirement plan based on total return.
That said, covered-call strategies may have their place in a total-return portfolio, because they modestly reduce the volatility of a portfolio. For example, from its January 2004 inception until August 2013, the CBOE S&P 500 BuyWrite Index's standard deviation was 11.2% compared with 14.8% for the S&P 500 Index. For retired investors who withdraw a fixed and growing income stream from a portfolio, reducing volatility means reducing the risk of running out of funds. The National Association of Personal Financial Advisors has determined that reducing the volatility of a portfolio with a 10% expected return and a withdrawal rate equal to 6% of the starting value showed that reducing portfolio volatility from 20% to 10% reduces the risk of running out of money over 30 years from 23% to 1%!
Options are powerful tools for creating a desirable risk/return profile. The risk/return profiles created by option strategies can useful for supporting withdrawal rates in retirement strategies, but they should never be used for the sole purpose of generating income.