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.