Tuesday, February 14, 2023

Covered Calls

Covered Calls

Similar to the legendary Rodney Dangerfield, Covered Calls don't "get no respect!" Although investors should always consult with their advisor, the Covered Call Investment Strategy has many appealing components, and may offer advantages to the classic "Buy-and-Hold" philosophy hammered into the psyche of the public by index fund providers. Indeed, much like Rodney Dangerfield, investors may come to love this strategy.

First let's have "the talk." If you are investing in the stock market it is by its very nature speculation, and as 2022 clearly demonstrated, it can be EXTREMELY volatile. Volatility is ten-letter word for "risk" or "loss" or "sleepless night" or "anxiety." Basically the opposite of a Bull Market, which can be summarized also with a single word: euphoria. 
Investors need to internalize the FACT that holdings in the stock market can and do fluctuate, and a "linear return" is fallacy in the short-term. On any given day, the markets can swing in multiple percentages up & down. As 2022 taught us, these downward trends can be sustained for months. For those old enough to remember to the 1970s, with the wrong economic policies these trends can be sustained for YEARS. That's the bad news.

Now on to the good news. Given that there are a limited number of places to put your hard-earned money in life (gold, stocks, bonds, real estate, and business ownership come to mind) there is a good chance some or most of your liquid assets will be held in the stock market.
Without diving too deeply into "the history of Wall Street," the stock market offers (generally) almost daily liquidity, established exchanges, and highly-regulated firms. All the major governments of the world are immersed in the global stock exchanges. So with that said, there is a reasonably good chance that owning a basket of stocks over time will turn out well.

As a Portfolio Manager (PM), my job is to select those securities which I have studied and researched which I believe with a high-level of confidence offer a solid rate of return for my clients. From a mechanical perspective, I also want to add a couple layers of additional protection. One, as frequently discussed on this blog, are dividends.
Dividends are cash payments companies make to their shareholders typically on a quarterly basis. It is a reminder to corporations as to who they work for, ie you. It also, obviously, a return on investment for the shareholder doled out at recurring intervals. Timing is notoriously tricky, but I believe it is better to get returns drizzled out over time than pray for a rainstorm.

Second, let's start embracing Covered Calls. Covered Calls are Call Options written (sold) on existing stock positions. These contracts are traded on similar hours as the underlying stocks themselves. Each Call Contract represents 100 shares of the underlying stock. So for example, if you own 1,000 shares of XYZ, then you could write up to 10 contracts on that position.
Part of the Portfolio Manager's job is to determine the likely TIME and LENGTH of that Covered Call. That is extremely challenging. It is often the confluence of volumes of data, and of course greed. How much do we think the stock will go up over a certain amount of time? Are we more concerned about losing the stock or leaving money on the table? How much is the premium paying? What is the likelihood of expiration without losing the stock?

A LOT of variables go into deciding the best course of action, and a lot depends on the client's goals. Ultimately, investing boils down to cash flow. Covered Calls are unique in the investing world in that you are paid UP FRONT for the premium on a contract in the future. Investors know with certainty how much they will be paid the moment the contract is sold. Cash from a Covered Call sale is deposited into investors' brokerage account instantly. And to segue to the third layer (first dividends, second Covered Calls),  that premium cash can then earn additional interest in very nice 5% Treasury Bills currently.

The art & science of Covered Calls is tricky, and like most things in life experience is probably the best teacher. One would think the primary goal is to maximize the premium return without getting the stock called away, but that is not always the case. There are also times where the stock WILL get called away by buyers who want to capture the dividend from investors. The biggest challenge for the PM starts with "the talk."

What is the client's annual return needs vs. wants vs. probability of accomplishing that goal? Is a $30K annual withdrawal on a $500K account reasonable? What is the implied risk? Can a client mentally forgo additional alpha if XYZ stock was purchased at $125 with Covered Calls written at $150 and the stock subsequently spikes to $175? Or like 2022, clients have a low cost basis and have been raking in dividends, premiums, and capital appreciation for years and suddenly find themselves down 15%, 20%, 25%. What then? This is why "the talk" is so important.

In summary, if you're on board with actively investing in the stock market I believe utilizing a Covered Call strategy makes sense for a lot of reasons; from security selection, cash flow certainty, hedging and tax-loss harvesting to name a few.
One of the greatest challenges, and one humans throughout time have been really, really bad at, is moderating greed. Adding layers of risk protection goes out the window the moment we say: "Well I'm gonna close out that contract and hold the stock now because it just keeps going higher. I don't want to miss out!" Letting hedges lapse is dangerous business.

By definition, employing a Covered Call strategy almost always involves getting some positions called away. That is the nature of the beast. But if 2022 taught us anything, it is that markets are inherently volatile and in any given year long-term investors can be subjected to gut-wrenching selloffs. I like having three (3) layers of added protection when investing in the stock market, that's probably why they call me "Mr. Covered Call!" If this strategy sounds appealing to you we should talk.
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