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Covered Call Options as Investment Strategies

An investment strategy that is highly underutilized is the selling/writing of call options on individual stocks or ETF’s that are owned within an investment portfolio.  I will cover three different S&P 500 option strategies which could all be implemented simply by using the S&P 500 ETF (SPY) and its underlying options.

All three strategies were invented and are tracked by the Chicago Board of Options Exchange (CBOE) and most are now being mimicked by mutual funds for personal investors.

The first strategy involves buying the S&P 500 and selling 1 month call options at the money every month and letting them expire.   This means that systematically if you own $1M of the S&P 500 and the index closes the month on the level 1,000 you sell $1M notional of 1-month call options with a strike of 1,000.  This would equate to $1,000,000/1,000 = 1,000 written 1-month call options on the S&P 500 at a strike of 1,000.  This process would be repeated every month upon expiration of the 1-month options.  This strategy is the simple At-The-Money (ATM) Buy-Write index which trades under the symbol BXM.

The second strategy is a simple extension of the BXM called the 2% Out-of-The-Money (OTM) Buy-Write Index under the symbol BXY.  As you could guess, the BXY simply sells 1 month call options 2% out of the money instead of at the money.  This provides the S&P 500 room to go up 2% per month without capping returns.

The last strategy is the Put-Write Index.  This strategy simply sells 1 month put options at the money while holding the equivalent notional amount in cash while earning interest.  Without getting into details, due to “Put-Call Parity“, the Put-Write index is theoretically equivalent to a covered call strategy.  The return/risk characteristics of this strategy are often more attractive than a simple covered call and I will cover those details at another time.

Hopefully you stuck with me to the meat of the matter – the results.

All of the option investment strategies exhibit *higher* returns and *lower* risk than simply investing in the S&P 500.

All of the option investment strategies exhibit *higher* returns and *lower* risk than simply investing in the S&P 500.

As much further proof for the efficacy of these option overlays, I looked at the period between January 1, 2000 and September 15, 2009.  We all know that this period was filled with the collapse of the internet bubble along with the recent credit crisis.  Two tumultuous times packed into less than 10 years.  The results for these strategies become even more endearing.

Under choppy market conditions, option overlays dramatically increase returns

Under choppy market conditions, option overlays dramatically increase returns

During the time period between January 2000 and now, you would have earned significant positive returns of 15% or greater with option overlays versus a loss of 14% by investing in the S&P 500 alone.  The put writing program would have generated returns that were 60% greater with a standard deviation which was 2/3 that of the S&P 500 alone.

This is only the tip of the iceberg of course, because we can always add complexity to these programs to increase their risk adjusted returns.  I just wanted to show that even the simplest introduction of options into a long only portfolio can dramatically increase its risk profile while adding income.  I will go into more complicated strategies in the future, but for now, why don’t you look at selling some call options on some of those stocks you own?

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6 Responses

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  1. Ralph P. says

    I was reading an old post about ATM put selling on the SPY. I understand the strategy on the upside. What happens on the down side? Do you roll out of the front month before assignment?

  2. SurlyTrader says

    If the market goes down you can do two things: 1) Let the option exercise in which you would buy the underlying at the strike, immediately sell the stock and sell another 1 month ATM put 2)Sell the put option that is expiring before it expires and roll to the next month.

    From a practical standpoint I think you would be better off selling the option before it expires and rolling to the next month. If you are strictly practicing a cash secured put position then you would want to sell out of the option instead of taking delivery because there would be a day or two where you do not have the short put option exposure.

  3. Esme Fisher says

    investing will always be a part of get rich programs, sometimes you need to be a risk taker to succeed.`-~

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