Covered Calls: The Income Illusion
Summary
TLDRIn 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
📉 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.
🔄 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.
📊 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.
Mindmap
Keywords
💡Covered Call
💡Option Premium
💡Strike Price
💡Risk-Adjusted Return
💡Sharpe Ratio
💡Skewness
💡Kurtosis
💡Mental Accounting Bias
💡Tax Efficiency
💡Manipulation-Proof Performance Measure
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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