Optimal Cover Call Writing

Buying an asset and selling a call against it is the most common investment strategy employed by individual option investors. This strategy is employed in a number of different ways.

  • Buy-Write / Covered Call: The simplest and most straight-forward method is known as buy-write and covered call strategy. In this strategy, where the investor sells calls on a 1 to 1 basis (1 call for every 100 shares owned.)
  • Overwriting: There is also the technique of overwriting, where the investor sells more calls than the amount of underlying they may own. That is to say, they sell more than 1 call for 100 shares they might own. Investors who are highly confident the share price will not rise through the upper strike employ this strategy.
  • Volatility Trading: Finally, there are investors who sell calls against the underlying instrument on a delta neutral basis. This is a more focused form of overwriting and is the foundation for selling volatility.

For the remainder of is article, we will be discussing the buy-write and our approach to systematically finding the best stock to employ this strategy. Many people think that covered call writing is a low-risk proposition. In some sense it is. If you already own a stock, you do not take on any additional downside risk by selling a call. You do however limit your upside. At the same time, many investors believe selling cash covered puts is a high-risk proposition. Truth be told, they have similar risks. To see this, let’s walk through an example.

Action Quantity Expiration Strike Type Net
Sell 1 90 Days $25.00 Call -$1.74
Buy 100 Stock $25.00
Net Cost $23.26

 

In this example, the investor owns a stock at $25.00 a share. They then sell a 90-day call option for $1.74. They are not in the trade at a cost of $23.26.

In the chart above, the blue line shows the profit/loss pattern of the buy-write at expiration. The dashed line represents the profit/loss pattern for an instantaneous change in the price of the underlying asset. Finally, the solid gray line shows the profit/loss pattern for the buy-write position after half the option’s time to expiration has passed away.

By viewing the chart, one quickly comes to the observations that a buy-write has far more downside risk than upside potential. In addition, an experienced options trader would recognize this as the payoff pattern for cash covered puts. A description of this structure is summarized below.

Action Quantity Expiration Strike Type Net
Sell 1 90 Days $25.00 Put -$1.74
Buy Cash $25.00
Net Cost $23.26

 

In this situation, the investor put up $23.26 in cash, sells a put option for $1.74 for a total of $25.00, which is equal to the strike price of the put sold. If the price of the stock falls, and the investor has to buy it from the owner of the put, they have the cash on hand to pay for it. Comparing the buy-write to the cash covered put is simply an example of Put-Call Parity, which is expressed by the following equation.

Cash + Call = Stock + Put

Rearranging this relationship we get.

Stock – Call = Cash – Put

This relationship holds so long as the expiration date and the strike price of the put and call are the same. Once you recognize the buy-write is essentially a put writing strategy, it becomes clear how one should design a method for finding the best covered-call investment opportunities. In the final analysis, the best assets with which to implement a buy-write are those that have less downside risk than the efficient market hypothesis (random walk)

From a statistical perspective, options are priced based on the assumption that future asset prices follow a random walk. A random walk implied that the statistical distribution of future prices looks like a bell curve.

The blue line in the chart above shows that probability distribution representative of a random walk. Notice that there is an equal probability of a rise in price and a fall in price. In addition, the probability of a large jump in price is the same as the probability of a large drop in price. It is this probability distribution that is incorporated into the pricing of options.

Since there is more downside leverage than upside potential in a buy-write strategy, one needs to find situations where the risk of a large drop is less than that assumed in option prices. The red line above represents a pictorial view of such a distribution. The red line indicates there is less downside price risk in the asset. At the same time, it has more potential for a small rise and a similar potential to a large rise in price. This might seem a bit wonky, but all we are looking to do is to sell puts or engage in a buy-write where the risk of a downside move is overpriced in the marketplace.

Method to Identify Stocks with More Upside Potential Than Downside Risk

There are a number of factors that drive the return characteristics of equity securities. We use these factors to identify securities that are more likely to rise in price than fall in price. In addition, these factors tend to provide “price support.” This does not mean that price cannot fall. The existence of these factors simply reduces the likelihood of an outsized drop in the share price. With a proper understanding of these factors, we can identify equities where downside risk is overpriced in the options market. The following is a discussion of the factors we look at to identify attractive buy-write situations.

  • Capital Structure: The stocks of companies that have a lot of debt on their balance sheet have more downside risk than companies that have no debt or a net cash balance. Consider the following example.
Share Price $25.00 $20.00
Assets Capital Structure Volatility Assets Capital Structure Volatility
Debt $75 75% 10.0% $75 79% 10.0%
Equity $25 25% 35.0% $20 21% 41.5%
Asset $100 100% 16.3% $95 100% 16.6%

 

Assume the company has a share price of $25.00 with a volatility of 35%. If the volatility of returns on the company’s debt is 10%, then the volatility of the company’s assets is 16.3%. Now assume the share price falls by 20% fro $25.00 to $20.00. The volatility of the company’s assets remains unchanged, as asset risk in independent of capital structure. But we see that a share price drop causes the volatility of equity to rise from 35% to 41.4%. That is to say, the equity becomes more vulnerable to downside risk as the share price falls as the probability of a large drop, increases.

Now consider the company with a different capital structure. In this example, not only does the company not have debt, it holds surplus cash on the books. The assets still have a return volatility of 16.3%. Since cash does not have volatility, the volatility of equity returns is just 13%.

Share Price $25.00 $20.00
Assets Capital Structure Volatility Assets Capital Structure Volatility
Debt -$25 -25% 0.0% -$25 -33% 0.0%
Equity $125 125% 13.0% $100 133% 12.2%
Asset $100 100% 16.3% $75 100% 16.3%

 

If the share price falls from $25 to $20, cash becomes a larger element of the market value of the company’s capital structure. Since cash does not have any return volatility, the volatility of the company’s equity must fall. In this case, equity return volatility falls from 13% to 12.2%. That is to say, the equity becomes less risky and the probability of a further large drop falls.

In the final analysis, companies with net cash on the books will become less volatile as the share price falls. One way to think about it is that the share price is highly unlikely to fall below the value of cash on the books, putting a hard floor under the share price.

  • Valuation: Valuation is a simple concept with respect to how it affects the distribution of potential returns for a stock. A company that trades at a PE of 30 has much more downside risk than a company trading at a PE of 5. Some investors prefer to look at cash flow as a better measure of value. Our favored measure of valuation relative to cash flow is Enterprise Value / Earnings Before Interest and Taxes (EV/EVIT). By the same token, a company where the market value of their assets is valued at 30 times cash flow has more downside risk than a company that trades at 5 times cash flow.
  • Share Repurchases: Companies that have excess cash on the books or generate more cash than is needed to grow the business often return money to investors through repurchase shares. Share repurchases have a number of benefits for company’s share price. First and most obvious is that it represents demand for the company’s shares. All other things held constant, more demand will help support if not increase a company’s share price. Share repurchases have a secondary benefit. They reduce the number of shares outstanding, which raises earnings per share and lowers the PE ratio. So long as the company does not borrow heavily to repurchase shares, a consistent share repurchase program helps support a company’s share price.
  • Dividends: A company that pays a dividend supported by earnings and cash flow is a signal that a company’s management is shareholder friendly and that management takes seriously their responsibility to provide a return to shareholders. Just as importantly, stability and growth of the dividend signals that management believes that the company will continue to perform well for the foreseeable future. This encourages new investors to buy the company’s stock and encourages existing shareholder to hold it. In addition, many investors will not buy a stock unless it pays a dividend. These types of investors tend to step in to buy stock in dividend-paying companies when they trade down, which raise their yield. This dynamic helps support a company’s share price. This factor reverses however when the dividend goes too high as a result of a falling share price. This is a signal that the company could be in financial distress and that a dividend cut and a further drop in share price are likely.
  • Volatility: The natural volatility of company assets is very important to the success or failure of a buy-write program. Since buying stock and selling a call is the same has holding cash and selling a put, directionality matters. A buy-write is a mildly bullish trade that is vulnerable to downside surprised. As a result, the ideal buy-write candidates are those with more upside volatility than downside volatility. Secondarily, one prefers realized volatility after the option is written to be less than long-term realized and implied volatility of the underlying security. Thirdly, one needs to be aware of an event. Implied volatility often rises before earnings announcement, investor days, permit approval dates (e.g. PIDUFA), etc. So we need to filter for those kinds of events as well. If realized volatility is running below implied and long-term realized volatility, then the price of the underlying is not likely to fall substantially if your investment thesis on the underlying stock is incorrect. At the same time, the stock is less likely to run through the upper strike in a bullish move. This allows the investor to hold on to their stock and sell another call option after the initial options sold expires worthless.

We examine every stock in the S&P 500 through the lens of these factors. We then rank them on a scale of 1 to 5 stars. Those stocks that have more exposure to these factors capture a higher rating.

To identify our favorite stock to sell covered-call on incorporates we look for stocks with a 3-star rating or better and that have some positive trading behavior. We like to write calls on stocks there price action is indicating investor enthusiasm for the company.

We publish this list of our favorite buy-write candidates and the ratings of all stocks in the S&P 500 on a weekly basis.

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