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Written by: Marc Odo | Swan Global Investments
Assessment and selection of covered call funds is based on criteria like total return, distribution rate (sometimes referred to as yield), and fees. Total return may be the most important as it drives the long-term sustainability of a fund’s distributions.
Total return in covered call strategies consists of three components: dividends collected, option income profits or losses, and capital appreciation or depreciation. A covered call fund or strategy selection should include consideration of a manager’s reliance on and relative strength in all three components, as each contributes to total return differently in various market conditions.
This post explores the expected performance of the components in different markets and their relative contribution to total return.
Covered Call Writing: Adding a Contributor to Total Return
Traditionally stocks and stock-based funds generate returns via two methods: the price appreciation of the stock itself and the dividends issued by the management of a company. These two components are the drivers of total return.
However, over the last couple of decades the dividend component of total return has become less important and investors more dependent upon price appreciation or capital gains to drive total returns. While the long-term average dividend rate for the S&P 500 from 1926 to 2024 was 4.0%, in each of the decades starting in 1990’s the dividend returns have been below its long-term average.
Covered Call Writing: An Option Strategy for Current Income
There is another option. Covered call strategies allow an individual investor to override a company’s income vs. growth policy with their own preferences.
With a covered call strategy, the investor owns a stock or a portfolio of stocks. They are fundamentally bullish on the stocks; otherwise they wouldn’t own them in the first place. However, with a covered call strategy, the investor prioritizes “cash in hand”, even if it comes at the expense of potential capital gains in the future.
This is accomplished via the writing of call options against the long equity positions. When writing (or selling, or shorting) a call option, the investor agrees to forgo capital gains past a certain price point in the stock. In exchange for surrendering upside opportunity beyond a price, the call writer receives an immediate cash payment, or “premium.”
This is analogous to the fundamental decision that a firm’s management makes when it sets the company’s dividend policy. Do their shareholders prefer cash-in-hand or long-term growth? An investor considering a covered call strategy must ask himself the same question. Does that investor prefer to write some options and “take some chips off the table,” or do they “let it ride” and hope for future gains?
It is important to realize that this represents a trade-off between immediate and delayed gratification. It is tricky to have both.
Typical Investor Misconception: Investors unfamiliar with options often hold a misconception that a covered call strategy on a stock, group of stocks, or equity index simply means they’ll gain some extra income on top of the price growth potential of their holdings, and there is no trade-off.
In an ideal world, an investor could write calls all day and retain all the upside potential, but you can’t have your cake and eat it too. Before embarking on a covered call strategy, investors should understand the fundamental trade-off between immediate income from covered call writing and potential long-term capital appreciation.
In addition, it should be noted that comparing a covered call strategy to a company’s dividend policy is an analogy, and it isn’t a perfect one. Dividends tend to be much more stable and predictable, whereas the profits and losses on a call writing strategy can be volatile. The analogy is useful in framing the trade-off between a known, immediate profit and uncertain future growth, but premium (or income) from call writing is not the same as dividends.
Since call writing can be volatile, it is Swan Global Investments’ opinion that actively managing a covered call strategy offers advantages over a passively managed approach. If a fund is passively managed a trade is established and then nothing is done until the options expire. This “set it and forget” passive approach will sacrifice capital gains should the written calls go in-the-money.
That scenario creates another dilemma.
If the manager cannot generate sufficient gains from options trades, dividends, or capital appreciation of the stock or index to cover the targeted or advertised distribution yield, then the manager will need to dip into the investment capital of the fund (investor’s money) and issue a return of capital to meet that target yield. In other words, the manager will return a portion of the investor’s original investment, less a management fee.
Alternatively, an active portfolio manager seeks to manage those risks. An active covered call strategy gives the portfolio manager the freedom and flexibility to change the terms of the trades in an attempt to strike the right balance between immediate income and future gains.
Summary
Covered call writing is one strategy an investor can employ to augment their immediate income needs. However, another fundamental finance lesson should be remembered – there is no free lunch.