Covered Calls: The Income Illusion

Summary

In this video, Ben Felix, a portfolio manager at PWL Capital, explains the pitfalls of covered call strategies and why they may appear more attractive than they actually are. He breaks down how covered calls exchange potential stock appreciation for option premiums, creating an illusion of high income. However, when total returns and risk factors like skewness are considered, covered call funds tend to underperform, are less tax efficient, and have higher fees. Felix argues that despite their appeal to behavioral biases, covered calls are typically a suboptimal investment strategy.

Takeaways

• 📉 Covered call funds may appear attractive due to high income yields and risk-adjusted returns, but this is largely due to financial product design rather than actual improvements in performance.
• 💼 The income from covered calls is not a true investment return, as it sacrifices the upside potential of the underlying stock in exchange for option premiums.
• 🔗 Selling call options involves liability, as the seller might have to sell shares below market value, which can negate the benefits of the option premium.
• 🧠 Investors are often misled by cognitive biases, like mental accounting, where they separate capital and income, making covered calls seem more beneficial than they are.
• 📊 Covered call strategies typically do not provide higher risk-adjusted returns unless the options are overpriced, making their high-income yields irrelevant or overstated.
• 📈 Traditional measures of risk-adjusted returns, like the Sharpe ratio, are inadequate for strategies involving options, as they fail to account for the skewed distribution of returns.
• ⚖️ Alternative metrics, such as the manipulation-proof performance measure, suggest that covered calls underperform simpler strategies when fees, costs, and taxes are considered.
• ⛔ Covered calls cap potential gains, which can be especially detrimental since stock returns rely heavily on upside potential, limiting long-term performance.
• 💸 Covered call funds are less tax-efficient and more expensive than simple stock or bond portfolios, further reducing their attractiveness.
• 🛑 Covered call strategies might only outperform in a flat market, but predicting market conditions is difficult, and these strategies generally miss out on long-term gains.

Q & A

What is the main appeal of covered call funds to investors?

Covered call funds attract investors due to their high-income yields and seemingly attractive risk-adjusted returns. However, these characteristics are a result of clever financial product design rather than actual improvements to returns or risk-adjusted returns.

What is a covered call in financial terms?

A covered call refers to selling a call option on a stock that you already own. The seller receives an option premium, but in return, gives up some potential upside if the stock’s price rises above a certain strike price.

Why are covered call strategies likely to perform poorly in the long run?

Covered call strategies limit the upside potential of the underlying shares, as the seller must sell the stock at the strike price if the option is exercised. This means any significant appreciation is missed, leading to poorer long-term performance.

How does the risk-adjusted return of covered calls compare to that of underlying assets?

Covered call strategies generally do not have better risk-adjusted returns than the underlying assets. The apparent attractiveness often stems from inadequate risk measures, which fail to account for factors like skewness and kurtosis in return distributions.

What is the common bias that makes covered calls appealing to some investors?

A mental accounting bias causes many income-oriented investors to treat income and capital separately. This cognitive error makes the income from covered calls seem appealing, even though it may not reflect actual net investment returns.

Why are covered call funds considered less tax-efficient?

Covered call funds typically distribute high levels of income, which can result in higher tax liabilities for investors in taxable accounts, making them less tax-efficient than simple stock or bond portfolios.

How does selling options affect the Sharpe ratio?

Selling options mechanically increases the Sharpe ratio by reducing the standard deviation (risk) while increasing skewness. However, this creates a misleading picture of risk-adjusted returns, as skewness itself is a form of risk that the Sharpe ratio does not capture.

What happens to covered call strategies in a flat market?

In a flat market, covered call strategies tend to outperform because the income from the option premiums is not offset by foregone stock appreciation. However, predicting a flat market is challenging, and missing out on positive returns in a rising market is a risk.

What is the manipulation-proof performance measure, and why is it relevant to covered calls?

The manipulation-proof performance measure is a metric designed to avoid manipulation through options and other complex strategies. When evaluated through this lens, covered calls tend to underperform simpler strategies that do not involve options.

How does the framing of covered call strategies make them seem more attractive?

Covered call strategies are often framed in a way that highlights multiple sources of profit—dividends, option premiums, and potential stock appreciation—while downplaying the potential losses from giving up large gains when stock prices rise significantly.

Outlines

00:00

📉 The Misleading Appeal of Covered Call Funds

Covered call funds are popular among investors due to their high-income yields and perceived strong risk-adjusted returns. However, this perception is often misleading. These funds are designed in a way that makes them seem more attractive than they are, without actually improving returns or reducing risk. The high income from covered calls comes at the cost of losing potential gains, as selling call options caps the upside. This results in a flawed risk-adjusted return profile, and covered call funds are generally less tax-efficient and more costly compared to traditional stock and bond portfolios.

05:02

🔄 The Mechanics and Pitfalls of Covered Calls

Covered call funds work by selling call options on owned stocks, generating income from option premiums. However, this strategy comes with the downside of losing potential profits if stock prices rise significantly. The income generated is not truly an investment return when considering the overall total returns. Many investors fall into the mental trap of viewing this income separately from capital gains, leading to an overestimation of the fund’s performance. In reality, covered calls rarely achieve better risk-adjusted returns than holding the underlying assets, as options pricing does not favor these strategies long-term.

10:02

📊 Risk Assessment and Covered Call Strategies

Evaluating covered call strategies requires understanding their impact on the distribution of returns. Traditional metrics like the Sharpe ratio are insufficient because they don't account for skewness introduced by options. While covered calls can reduce standard deviation, they also limit upside potential, thus increasing skewness. This skewness represents a form of risk that is often ignored in traditional risk assessments, making covered call funds appear more attractive than they are. More robust metrics that account for skewness show that these strategies tend to underperform their underlying assets, even before considering fees and taxes.

Keywords

💡Covered Call

A covered call is a financial strategy where an investor holds a stock and sells a call option on that stock. The video explains that covered calls are often used by investors to generate income through option premiums. However, it also highlights that this strategy can limit the upside potential of the stock, as the investor may be forced to sell the stock at a lower price if the option is exercised. The video critiques this strategy as potentially misleading, offering the appearance of high income while masking the risks involved.

💡Option Premium

An option premium is the price that an option buyer pays to the seller for the right to buy (call) or sell (put) an asset at a specified strike price. In the context of the video, option premiums are a source of income for investors using covered call strategies. However, the video argues that this income is not a true investment return because it is offset by the potential loss of upside in the underlying stock.

💡Strike Price

The strike price is the set price at which the buyer of a call option can purchase the underlying asset, or the price at which the buyer of a put option can sell it. In the covered call strategy discussed in the video, selling a call option at a strike price above the current market price can generate premium income, but it also caps the potential gains if the stock price rises above the strike price.

💡Risk-Adjusted Return

Risk-adjusted return measures an investment's return relative to the risk taken. The video emphasizes that covered call strategies often appear to offer high risk-adjusted returns, but this is a result of flawed financial product design rather than actual performance. The video argues that traditional metrics like the Sharpe ratio may inadequately assess the true risks involved, especially given the skewness and kurtosis introduced by options.

💡Sharpe Ratio

The Sharpe ratio is a common measure of risk-adjusted return, calculated as the ratio of an asset's excess return over the standard deviation of that return. The video criticizes the Sharpe ratio for being inadequate in evaluating covered call strategies, as it does not account for the skewness and kurtosis that options introduce to the return distribution. This can lead to a misleadingly high Sharpe ratio, making the strategy appear more attractive than it is.

💡Skewness

Skewness refers to the asymmetry in the distribution of investment returns. Positive skewness indicates more frequent small gains with occasional large losses, while negative skewness indicates frequent small losses with occasional large gains. The video discusses how covered call strategies increase skewness by cutting off the right tail of the return distribution, which can make the strategy appear safer in traditional risk measures, but in reality, it introduces another form of risk.

💡Kurtosis

Kurtosis is a statistical measure that describes the 'tailedness' of the distribution of returns. High kurtosis indicates more frequent extreme returns, either positive or negative. The video explains that options, like those used in covered call strategies, affect the kurtosis of return distributions. Ignoring kurtosis can lead to inadequate assessment of the true risks associated with covered call strategies, as they often increase the likelihood of extreme outcomes.

💡Mental Accounting Bias

Mental accounting bias refers to the tendency of individuals to separate money into different 'accounts' based on subjective criteria, often leading to irrational financial decisions. The video points out that covered call strategies exploit this bias by making investors focus on the income from option premiums without fully considering the potential capital losses from selling the underlying stock below market value. This bias can make the strategy seem more appealing than it is.

💡Tax Efficiency

Tax efficiency refers to how much of an investment's return is retained after taxes. The video argues that covered call funds tend to be less tax-efficient compared to simple stock or bond portfolios due to their high distributions, which are taxed more heavily. This inefficiency, combined with higher fees, makes covered call strategies less attractive when considering total returns after taxes.

💡Manipulation-Proof Performance Measure

The Manipulation-Proof Performance Measure (MPPM) is a performance evaluation metric designed to be resistant to manipulation through strategies like options trading. The video highlights that, unlike the Sharpe ratio, the MPPM accounts for skewness and other complexities in return distributions, providing a more accurate assessment of investment performance. Covered call strategies tend to underperform when evaluated using the MPPM, indicating that their apparent risk-adjusted returns may be overstated.

Highlights

Investors are attracted to covered call funds due to high income yields and seemingly high risk-adjusted returns.

The appearance of high income in covered call strategies is due to clever financial product design, not actual improvements in returns.

Covered call income is not a true investment return, as it exchanges potential upside for option premiums.

Covered call strategies are likely to underperform in the long run, especially when total returns are considered.

The risk-adjusted returns of covered calls seem attractive only when risk is inadequately measured.

Covered calls are less tax-efficient and more expensive compared to traditional stock and bond portfolios.

A common bias among income-oriented investors is treating income and capital separately, which makes covered calls appealing.

The Sharpe ratio, commonly used to measure risk-adjusted returns, is inadequate for evaluating strategies involving options.

Covered call strategies reduce standard deviation but increase skewness, altering the risk distribution in ways that the Sharpe ratio doesn't account for.

The manipulation-proof performance measure shows that covered call strategies underperform less complex strategies when risk is measured properly.

In flat markets, covered call strategies may outperform as option premium income is not offset by foregone appreciation.

Market timing is difficult, and covered calls increase the risk of missing out on positive returns in growing markets.

Despite high distribution yields, covered call strategies do not offer attractive risk-adjusted returns when fully evaluated.

Covered call strategies can appeal to behaviorally biased investors who mentally separate capital and income for spending purposes.

Covered call funds tend to underperform, even before accounting for fees, taxes, and higher implementation costs compared to simple index funds.

Transcripts

some investors are attracted to covered

call funds because of their High income

yields and seemingly High risk-adjusted

returns however the appearance of high

income and high risk adjusted return is

the result of clever Financial product

design not of actual improvements to

returns or risk adjusted returns

covered call income is not really a net

investment return covered calls are

likely to perform poorly in the long run

and the risk-adjusted returns of covered

calls are only attractive when risk is

measured inadequately additionally they

tend to be less tax efficient and more

expensive to own than simply investing

in a portfolio of stocks and bonds

I'm Ben Felix portfolio manager at pwl

Capital and I'm going to uncover the

misleading claims that make covered call

ETFs seem more attractive than they

really are a call option is a financial

contract that gives the option buyer the

right but not the obligation to purchase

a security at a set price called the

strike price a call option that is in

the money can be exercised to purchase

the underlying security below its market

price a covered call means selling a

call option on a stock that you own

receiving an option premium in return in

covered call funds option premiums are

usually distributed to unit holders

creating the appearance of extremely

high income yields but covered calls

exchange option premiums for lost upside

potential on the underlying shares this

means that the income they distribute is

not really an investment return When

total returns are considered when an

option is sold the seller receives

income from the option premium but they

also take on the liability that the

option could be exercised requiring them

to sell the underlying shares below

market value to the option buyer this

embedded liability can more than offset

the option premium income but that's

easy to miss due to the mental

accounting bias that causes many people

to treat income and capital separately

in their minds this bias is common among

income oriented investors and covered

calls appeal to investors biases and

cognitive errors in reality we would not

expect covered call strategies to have

higher risk-adjusted returns than their

underlying assets unless options are

overpriced making the income yield

figure that people often get so excited

about somewhere between irrelevant and

overstated the measure of risk matters a

lot in making judgments about

risk-adjusted returns options affect

higher moments of the return

distribution including skewness and

kurtosis a common measure of risk

adjusted returns is the sharp ratio the

ratio of an asset's excess return over

the standard deviation of the excess

return this metric is inadequate for

assessing the performance of strategies

containing options due to their effect

on the shape of the distribution

the sharp ratio follows Harry Markowitz

mean variance framework which assumes

that the mean and standard deviation of

single period returns are sufficient for

evaluating the relative attractiveness

of investment portfolios if you imagine

a normal distribution which is fully

described by its mean and standard

deviation the distribution of outcomes

will be symmetrical about the mean

writing call options slightly improves

the left tail by the amount of the

option premium and completely cuts off

the right tail at the option strike

price reducing standard deviation while

increasing skewness the effect is a

mechanical increase in the sharp ratio

but skewness is another form of risk

that investors care about so ignoring it

in the evaluation of risk adjusted

returns for a strategy that we know has

a skewed distribution simply does not

make sense

other evaluation metrics better suited

to assessing strategies with skewed

distributions demonstrate that covered

calls will tend to underperform their

underlying assets even before fees costs

and taxes are considered this should not

be a surprise given how important the

right tale of the distribution which is

cut off in a covered call strategy is to

stock returns investment managers make

game whether intentionally or not you

can be the judge common performance

evaluation metrics like the sharp ratio

by using options and other complex

strategies this gaming works even in the

face of high costs metrics like the

aptly named manipulation proof

performance measure have been developed

specifically to be free from option

related manipulation and through this

lens covered calls are dominated by less

complex strategies another way to

explain all this is that any abnormal

risk-adjusted performance of covered

call writing is largely driven by the

disregard of skewness

to be fair even if an objective

assessment suggests that covered calls

are sub-optimal the strategy may be

useful for behaviorally biased investors

who rely on the mental separation of

capital and income to determine their

spending and wants to spend down their

portfolio aggressively my comments so

far have mostly ignored fees costs and

taxes but these are major considerations

due to their High distributions covered

call funds will typically be less tax

efficient for taxable investors than the

underlying stock index and their fees

will tend to be higher using xyld as an

example the fee to own the fund is 60

basis points compared to 10 basis points

for spy and three basis points for vo

products implementing covered call

strategies will also tend to have higher

implementation costs than simple index

funds investing in the same underlying

assets taking a step back and looking

more broadly at a sample of mutual funds

in general live funds using covered

calls tend to underperform measured by

excess return and the manipulation proof

performance measure it is true that in a

flat Market covered call strategies will

outperform since the option premium

income will not be offset by foregone

appreciation in the underlying

securities an investor who believes that

the market or a segment of the market

will be flat or slightly negative May

Implement covered calls to generate

returns but Market timing is hard it's

not possible to predict a flat market

and covered calls introduce the

possibility of missing out on positive

returns which over time tend to outweigh

flat and negative returns covered call

funds are often sold as high income

strategies with attractive risk-adjusted

returns examined with appropriate

consideration for Total return and

assessment tools that account for

skewness in the distribution of returns

they are neither High income nor do they

have attractive risk adjusted returns

they appeal to the behavioral biases and

cognitive errors of investors which in

some cases may be fine but in general

and especially for investors who want to

behave rationally covered calls are an

objectively sub-optimal strategy most of

the time thanks for watching I'm Ben

Felix portfolio manager at pwl Capital

if you enjoyed this video please share

it with someone who won't stop telling

you about their covered call ETFs

before you go I want to share a couple

of short clips from mayor statman and

cam Harvey two giants in the world of

academic Finance discussing some of the

topics that I covered in this video both

Clips are from episodes of my podcast

the irrational reminder podcast

that's a really nice way to explain it

from the other direction

what about strategies like uh like

covered calls and Structured Products

why are those so attractive to normal

investors

well they're attractive because of of

the way they are framed ah people hate

losses and they hit hate the prospect of

losses uh and so let's say that that you

uh

buy a share and and a broker says to you

you know why don't you do covet calls

why don't you sell call options uh

against it and and they say look in fact

I take that from a manual for Brokers uh

by by gross and and what he says is

you're going to have in a Cupboard call

three posts three uh sources of profit

first you still hold the stock

so you'll get dividends that's one

source uh second you'll get a premium

from selling that car that's another

source and throw it because you're going

to write that call with an exercise

price higher than the current price you

will have the third one because if it is

called uh then let's say that that the

exercise price is 55 and the stock is at

50 you'll still get that five percent

uh five five dollar rather between 50

and 55 dollars and then he says you know

what you're going to lose are those

uncertain things that happen if the

price goes beyond 55 but of course

if you uh find that the stock price has

gone not to 55 but to 75 you're going to

again feel like an idiot with regrets

and so what people do people are kind of

fooled by this framing of three sources

of losses and they don't realize that

when they buy a call somebody is selling

that call and that somebody might not be

stupid uh that somebody might know

something and that that you don't and so

and so it is really again rationally

speaking uh it makes little sense but

behaviorally normally it does it does it

make sense and so uh this is covered

calls

do you think that's being used enough in

practice like we still hear about mean

and variance a ton and not not as much

about cenus

yeah it's remarkable to me that it's

been so many years

and we still make the mistake

of operating in like a mean and variance

world

uh it or people will take a look at

different investment strategies and pick

the one with the highest sharp ratio

well

let's take a step back

the high sharp ratio might be a strategy

that has got a giant downside

so it's got negative skew and then the

lower sharp ratio maybe has the positive

skew so so the variation in the sharp

ratio is purely

explained by the risk

so this is really important because

often people will claim that their

trading strategies got like some Alpha

uh and and then you ask them well how

are you measuring that Alpha as well

we're using the capital asset pricing

models

well that's only appropriate if you only

care about mean and variance

so you could have

um you know a giant downside

and that's generating on average higher

returns

but it's but it's purely a risk indeed

I've got an exam question that I've used

and hopefully my students don't listen

to your podcast

um so and it is a true story

um

that a student gets me on the phone an

alumnus so graduated a number of years

ago and

wanted to use some of my materials was

seeking permission

and I said well what do you do

and they said well we're incredibly

successful we're close to a billion

dollars uh AUM and the strategy is

really simple all we do is we buy the s

p 500.

uh nothing fancy

but then we consistently write out of

the money put options

and and then we've done like two to

three hundred basis points of Val file

uh every year and and the fund is

growing

so I have had many students I thought

this might be one of my students and I

said you didn't take my course and asset

management did you

and they said uh no I I didn't take it

but that was a mistake

I said well

um I know you didn't take it because you

actually have zero Alpha

what you're doing is just increasing the

risk of the portfolio the what you think

is Alpha is just a compensation

protecting risk and at some point

there's going to be a drawdown in the

market and and you're going to greatly

underperform

[Music]

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