Article written by Dr Scott Niblock, Lecturer and researcher in Finance at the School of Business and Tourism, Southern Cross University
Increased market volatility and risk constraints are changing the way modern investment portfolios are being managed. This is particularly the case for money managers and investors seeking to generate income from or reduce downside price risks of their investment portfolios. Moreover, in light of ongoing market uncertainty, there has been growing demand for financial derivatives (e.g options) and income/portfolio hedging strategies (e.g covered calls, credit spreads, protective puts, etc.) in the Australian retail investment environment.
Covered call writing (or ‘buy-write’) is an example of a popular options-based strategy used in flat or side-ways trending markets. The covered call is essentially utilised as a ‘buy-and-hold’ strategy, whereby a stock is purchased and a short-dated (ie. one-month), call option contract on the stock is simultaneously written to generate income and capture limited upside price appreciation. The covered call strategy essentially produces income through the collection of sold call options and converts the prospects of uncertain future capital gains into immediate cash flows. In addition, the strategy reduces the average cost of acquiring the stock and offers defined payoffs. The asset pricing literature also provides evidence indicating that the strategy is effective in lowering overall portfolio volatility.
Although the income generated from call writing provides partial protection against small declines in the stock price, it also creates an opportunity cost. For instance, call writing caps profits due to the writer’s obligation to sell at the contracted exercise (or strike) price and expiry date. The merit of the strategy is therefore compromised when markets rise rapidly or are ‘bullish’, as the investor is not able to fully participate in strong upward movements of the stock price; thus, resulting in underperformance versus the standalone buy-and-hold portfolio.
So does the covered call strategy add value for investors? In a recent study, I examined the performance of monthly covered call option strategies using a ‘blue-chip’ Australian equity portfolio (e.g stocks listed in the S&P/ASX 20 index) from 2010 to 2015. The results showed that covered call writing produces similar returns at lower risk when compared against the standalone buy-and-hold portfolio, and that market volatility seems to be a significant driver of covered call writing performance in Australia.
Overall, covered call strategies based on blue-chip stock portfolios appear to create value for fund managers and investors in the Australian stock market. Such strategies may be useful for those seeking income, market neutral asset allocation and less risk exposure in volatile market environments. However, further research that attempts to better understand the strategy over varied market conditions, along with the design/improvement of additional strategies that mitigate the effects of persistent market volatility on investment portfolios, is needed.
This article originally appeared in the Business Insight section of the Gold Coast Bulletin newspaper and is for general information purposes only.
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