With interest rates currently at all-time lows, it can be a challenge to find ways to generate income in a security portfolio. The strategy of writing covered call options (WCCO), whether applied systematically or on an ad hoc basis, can be used to generate additional income in the form of the premiums received from writing the calls.
In this article you will learn how to generate revenue using this strategy.
Using the covered call writing strategy to systematically generate income consists of writing one call option contract for every 100 securities held in a portfolio, and repeating the operation from one expiration date to the next regardless of market conditions. This strategy is generally used with index ETFs (exchange-traded funds) because they are less sensitive to the publications and news that can affect individual securities. Even though the selected call options are generally at-the-money and expire in approximately 30 days, in-the-money or out-of-the-money options with weekly or annual expirations can also be used.
For the purposes of this article, we will consider a portfolio that replicates the writing of covered call options by taking a long position in units of iShares S&P/TSX 60 (XIU) as well as a short position in near at-the-money XIU call options with an expiration of close to 30 days. Following their expiration, a new series of call options with the same characteristics are written on the XIU units. This systematic use of covered call option writing produces results that we can compare to simply holding XIU units.
Chart 1: Comparison of the XIU WCCO portfolio with XIU units from October 4, 1999, to January 17, 2020
As the above chart shows, in the period from October 4, 1999, to January 17, 2020, the XIU WCCO portfolio generated a higher return than the XIU ETF, and with lower volatility. We can also see that, during periods of sustained growth, the XIU WCCO portfolio underperformed due to the income not captured above the strike price of the call options written. In contrast, the XIU WCCO portfolio performed better during periods of sharp decline, due to the premiums received on writing the call options. Although nothing is fail-proof, similar results could be obtained by using this strategy on other index ETFs.
Instead of applying the strategy systematically, it could be implemented on an ad hoc basis. In this case, the investor chooses the most appropriate time to write call options on the shares of stocks or ETFs held, based on an analysis of the underlying security. This analysis is usually technical. The investor will try to anticipate the trend reversal that may occur following a sharp rise in prices when price growth is losing momentum. The most widely used technical indicator for anticipating such reversals is the Relative Strength Index (RSI), which seeks to measure the strength of movement in one direction or another. When this movement runs out of steam and the security is in overvalued or undervalued territory1, the conditions for a trend reversal are very likely present (of course, nothing is guaranteed).
Chart 2: RSI based on daily price changes in XIU to July 9, 2020 ($23.65)
The above chart shows changes in RSI2 as a function of daily changes in the price of XIU from January 2019 to July 9, 20203. As you can see, there are six periods during which the RSI was in overbought territory, with a reading over 70. In a context of ad hoc income generation, these times could have been used to write covered call options. This very simple technique may not be perfect, but it has the advantage that the investor does not write call options when the security’s price is relatively low.
Several other indicators or techniques may be used in combination to more accurately determine whether the security is in overbought territory. Here the objective is to hold the security for as long as possible before writing the calls. Once the options have been written, the position will be held until the call options either expire or can be bought back for a price between 10% and 20% of their initial value.
Should the security price continue to rise rather than pause or decline, the call options will likely be exercised by their holder and the investor will be forced to sell the underlying securities. In this case the investor will receive a notice of assignment. It is always up to the investor to decide whether to hold the options until expiration and run the risk of being assigned. To avoid being assigned, the investor can buy back the call options written before they expire, possibly at a loss.
The covered call writing strategy can be used to generate income in one of two ways:
• Applied systematically and independent of what may be happening in the market, this technique can generally be used to generate returns that are equal to or even better than those achieved by simply holding the underlying security, and with much less volatility.
• Investors interested in trying to optimize this strategy should consider the ad hoc approach. In this case, the investor will try to hold on to the underlying security for as long as possible as it trends upward, only writing covered calls when the security shows signs of weakening. Several indicators can be used in combination in order to arrive at a decision.
The strategies presented in this column are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
1RSI varies in a range from 0 to 100. A reading below 30
generally indicates that the security is oversold, and a reading
above 70 indicates it is overbought. To learn more about this
indicator, conduct a search on the topic using your preferred search
2 We used the default settings for RSI, i.e., a period covering 14 trading sessions.
3Note that this analysis is of no real significance and is used here for educational purposes only. An analysis covering a longer period of time, combined with other indicators, may produce more conclusive results in either direction.
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