Covered Call Strategies for a Falling Market

Financial contracts come in different forms and sizes. But one thing they have in common is that they require a buyer and seller. A call option is a contract that involves two parties who agree to buy and sell a financial asset by a certain time at a specific price. In some cases, the seller doesn’t own the underlying asset. In other cases, they may possess the security. The latter case is referred to as a covered call. But how does this work? In this article, you’ll learn more about covered calls, how the strategy works, and how to apply leverage to further increase capital efficiency and potential profitability.

What Is a Covered Call?

A covered call is a financial transaction where the investor who sells the call options owns the same amount of the underlying asset. Put simply, a covered call is a trading option where someone sells a call option on an asset they own. Since the owner has possession of the asset in a covered call, the seller can deliver the asset if the buyer decides to exercise the option.

Covered call strategies can be useful to generate profits in flat markets. In some scenarios, covered calls can provide higher returns with lower risk than their underlying investments. There are three methods for implementing such a strategy through the use of different types of securities:

While all of these methods have the same objective, the mechanics are very different, and each is better suited to a particular type of investor’s requirements than the others.

How Covered Call Strategies Work

Covered call strategies pair a long position with a short call option on the same security. The combination of the two positions can often result in higher returns and lower volatility than the underlying index itself.

For example, in a flat or falling market, the receipt of the covered call premium can reduce the effect of a negative return or even make it positive. When the market rises, the returns of the covered call strategy typically lag behind those of the underlying index but will still be positive.

However, covered call strategies are not always as safe as they appear. Not only is the investor still exposed to market risk, but also the risk that the premiums accumulated over long periods may not be sufficient to cover the losses. This situation can occur when volatility remains low for a long time and then climbs suddenly.

Applying Leverage to Covered Calls

Leveraged investing is the practice of investing with borrowed money to increase returns. The lower volatility of covered call strategy returns can make them a good basis for a leveraged investment strategy.

For example, if a covered call strategy is expected to provide a 9% return, the investor can borrow capital at 5% and maintain a leverage ratio of 2 times ($2 in assets for every $1 of equity). The investor can expect a 13% return (2 × 9% – 1 × 5% = 13%). If the annualized volatility of the underlying covered call strategy is 10%, then the volatility of the 2 times leveraged investment would be twice that amount.

Of course, applying leverage only adds value when the underlying investment returns are significantly higher than the cost of the borrowed money. If the returns of a covered call strategy are only 1% or 2% higher, then applying 2 times leverage will only contribute 1% or 2% to the return but would increase the risk sharply.

Covered Calls in Margin Accounts

Margin accounts allow investors to purchase securities with borrowed money. If they have both margin and options available in the same account, a leveraged covered call strategy can be used by purchasing a stock or ETF on margin and then selling monthly covered calls.

But, there are some potential pitfalls with this strategy.

• Margin interest rates can vary widely. One broker may be willing to loan money at 5.5% while another charges 9.5%. As shown above, higher interest rates will cut profitability significantly.
• Any investor who uses broker margin has to manage their risk carefully, as there is always the possibility that a decline in value in the underlying security can trigger a margin call and a forced sale. Margin calls occur when equity falls to 30% to 35% of the value of the account, which is equivalent to a maximum leverage ratio of about 3.0 times.

While most brokerage accounts allow investors to purchase securities on a 50% margin, which equates to a leverage ratio of 2.0 times, at that point it would only take a roughly 25% loss to trigger a margin call.

To avoid this danger, most investors would opt for lower leverage ratios; thus the practical limit may be only 1.6 times or 1.5 times, as at that level an investor could withstand a 40% to 50% loss before getting a margin call.

Covered Calls With Index Futures

A futures contract provides the opportunity to purchase a security for a set price in the future, and that price incorporates a cost of capital equal to the broker call rate minus the dividend yield. Futures are primarily designed for institutional investors but are increasingly becoming available to retail investors.

As a futures contract is a leveraged long investment with a favorable cost of capital, it can be used as the basis of a covered call strategy. The investor purchases an index future and sells the equivalent number of monthly call-option contracts on the same index. The nature of the transaction allows the broker to use the long futures contracts as security for the covered calls.

The benefit is a higher leverage ratio, which is often as high as 20 times for broad indexes. This creates tremendous capital efficiency. The burden is on the investor, however, to ensure that they maintain sufficient margin to hold their positions, especially in periods of high market risk.

Because futures contracts are designed for institutional investors, the associated dollar amounts are high. For example, if the S&P 500 index trades at 1,400 and a futures contract on the index corresponds to 250 times the value of the index, then each contract is the equivalent of a $350,000 leveraged investment. For some indexes, including the S&P 500 and Nasdaq, mini contracts are available at smaller sizes.

LEAPS Covered Calls

A LEAPS option is an option with more than nine months to its expiration date. The LEAPS call is purchased on the underlying security, and short calls are sold every month and bought back immediately before their expiration dates. At this point, the next monthly sale is initiated and the process repeats itself until the expiration of the LEAPS position. Like any option, the cost is determined by the:

• Intrinsic value
• Interest rate
• Amount of time to its expiration date
• Estimated long-term volatility of the security

LEAPS call options can be expensive because of their high time value, but the cost is typically less than purchasing the underlying security on margin.

Because the investor tries to minimize time decay, the LEAPS call option is generally purchased deep in the money. This requires some cash margin to be maintained to hold the position. For example, if the S&P 500 ETF trades at $130, a two-year LEAPS call option with a strike price of $100 would be purchased and a $30 cash margin held, and then a one-month call sold with a strike price of $130, i.e., at the money.

By selling the LEAPS call option at its expiration date, the investor can expect to capture the appreciation of the underlying security during the holding period (two years, in the above example), less any interest expenses or hedging costs. Still, any investor holding a LEAPS option should be aware that its value could fluctuate significantly from this estimate due to changes in volatility.

If the index suddenly gains $15 in the next month, the short call option will have to be bought back before its expiration date so that another can be written. In addition, the cash margin requirements will also increase by $15. The unpredictable timing of cash flows can make implementing a covered call strategy with LEAPS complex, especially in volatile markets.

The Bottom Line

Leveraged covered call strategies can be used to pull profits from an investment if two conditions are met:

1. The level of implied volatility priced into the call options must be sufficient to account for potential losses.
2. The returns of the underlying covered call strategy must be higher than the cost of borrowed capital.

A retail investor can implement a leveraged covered call strategy in a standard broker margin account, assuming the margin interest rate is low enough to generate profits and a low leverage ratio is maintained to avoid margin calls. For institutional investors, futures contracts are the preferred choice, as they provide higher leverage, low interest rates, and larger contract sizes.