And, is it any good?
This is a Covered Call (CC) strategy, so if you hate them skips to the next post. Also, I won’t review here what a CC strategy is as there myriads of videos and write ups on the subject.
In general, CC strategies do not sit well with seasoned investors as they cap the upside gains and provide limited protection to the down side in the form of option premium. Why bother with a 1-2% monthly return when the market is falling like a brick? That’s true for the most part. But given that option premium are linked to implied volatility (iVol), and markets are experiencing turmoil, the VIX which is one way of reflecting iVol, is at a mid level of ~25-29. Thus, option premiums are higher than usual.
For example, Wells Fargo (WFC) is paying 1.80$ for At-The-Money (ATM) Calls expiring 4 weeks down the road. With the share price at 40$, that’s 54% (1.80x 12 /40) potential annual return, before changes in share price. For comparison, the famous QYLD ETF, that pays annual “dividends” of ~12% from ATM option premium looks like it’s ripping off investors as a similar approach using QQQ can yield +4% monthly return, without paying the 0.6% annual fees.
Can we do better? In April 2022 CME launched daily options for the E-Mini futures. So now there are 5x/week expiring option chains as opposed to the previous 3x/wk calendar. In principle, at 3:50 pm ET every day one can write ATM calls against E-Mini futures (ES), valued @3,800 while getting ~22/day. Here we are talking a high 145% max potential annual return (22 x5days x50 weeks /3800) based on option premium, again before including share price variation. These numbers are just a nominal reference as futures are purchased on margin. For example, in a portfolio margin account a CC position in ES requires 20M$. The leverage here is significant as one Mini-ES futures has a notional value of 50x the index, right now @3,800x50= $190,000. So, the theoretical max returns on margin are much higher: (22x50x250)/20,000 = 1,375%. Careful with theses numbers as CC are net long and the leverage plays against you just as much. More on risk latter.
The Chicago Board Options Exchange (CBOE) came up with a monthly CC index based on SPX with data from 2002. It’s called BMX, where one buy the SPX index and then writes ATM call options.
The results are quite interesting. Starting in 2002, it took SPX until 2017 to surpass BXM, assuming one reinvest the Option premium. Not bad for a strategy viewed as having limited upside potential.
And, they use monthly options which provides significantly less premium over a 12 month period. How much less versus the new dailies? Over 4x at equivalent VIX.
How soon can we recuperate from a market decline? Another way of looking at risk. Let’s use an example pull out of the hat. In this bear market, the SPX bottoms at 2,000, overshooting the march 2019 low of 2174. From the current 3,800-2,000 = 1,800 pts x 50$/point there is -$90,000 loss for each Mini-ES contract. At the current daily premium of 22, it would require 82 days (1,800/22) to cover that amount. The option multiplier for ES options is 50, just like the outright contract. By the way, the current 22 in option premium would certainly move much higher as the VIX creeps up. Again, no bad for strategy that’s usually perceived as having little downside protection.
The risk increases as the speed of decline accelerates since there are not enough days to gain that protective premium. But, quick downturns like the one in March 2020 can be overcome with Tail Hedging for as low as 1-1.5%/year as the explosive gains in iVol fuel Out-The-Money protective puts. But that’s another post.
As I was writing this note the VIX increased by 2.4pts to 29.8 and the ATM calls option expiring tomorrow went from 22 to 30.
To close. Is it a MI strategy? I guess so as it’s pretty mechanical. Everyday before the market ends, one close the current day positions and open a new one for next day. Rinse and repeat everyday. A small twist is to use only naked calls, instead of the usual CC combination, when the market is below the 200 day moving average and therefore falling. This changes the profile of the position into a net short. And move back to regular CC when the market is above the 200 SMA.
Any thoughts? What am I missing?