Own the probable, sell the improbable.
There has been a massive proliferation of option-related ETFs over the last several years. Income, hedged equity, buffers, and defined outcome ETFs continue to see greater popularity as they offer more elegant solutions to common portfolio needs than the equity/fixed income split that became so common. Focusing on option income ETFs, products have become a bit more elevated now that active management within ETFs is allowed. However, they still tend to mostly focus on maximizing income distributed back to investors by writing at-the-money calls. The active management component has helped in how these positions are rolled and more thoughtful strike selection. Nonetheless, most covered call products still focus on producing most of their total returns from the monthly options they sell. Fortunately, Nasdaq acquired Volos, a company that has institutional grade back testing capabilities of options strategies. Starting with a basic comparison between holding SPY and an at-the-money covered call strategy on SPY (SPY Covered Call ATM), we can clearly see the cost of a covered call strategy over the last 21 years.
When we dig further into the two strategies, annualized returns for SPY vs SPY Covered Call ATM are 11.18% and 7.16%, respectively. Some may say, of course the returns are worse for the covered call strategy, but the volatility is lower. That is true. Annual volatility for SPY Covered Call ATM is 13.35% and its max drawdown is -36.62% compared to annual volatility for SPY of 19.09% and a max drawdown of -55.20%. Finally, looking at return/risk, SPY is better than the SPY Covered Call ATM with a return/risk of 0.59 vs 0.54. So, the consistent monthly income and lower volatility is not enough for the SPY Covered Call ATM strategy to outperform SPY on a risk-adjusted basis. This gets back to the key drawback of covered call strategies; they are forgoing the right tail of the distribution of market returns for income. Sometimes, this is a great trade, but it is particularly disastrous coming off market bottoms. For example, in 2020 the SPY Covered Call ATM strategy was flat while SPY gained just over 18%. The 2020 difference in max drawdown was only 5%. While an extreme example, 2020 highlights the risks going with an at-the-money covered call strategy. As it turns out, we can mitigate these risks by selling out-of-the-money (OTM) options. The table below contains the results of covered call strategies with targeting varying levels of how far out-of-the-money to sell a call each month.
All the covered call strategies lag the market if just looking at cumulative returns, but three strategies have higher return/risk metrics than SPY. Perhaps unsurprisingly, the strategies with the highest return/risk metrics sold the furthest out-of-the-money options. While their median monthly incomes are lower than the SPY Covered Call ATM strategy, they are far better at maximizing the benefits of writing calls on a portfolio basis. One of the key reasons for this is the ability of the further OTM strategies to participate in most of the market’s return while generating meaningful option income in more volatile markets and thus lowering volatility more during those periods. For example, the SPY Covered Call 4% OTM strategy only produced a median monthly income of 0.21% over the entire back test period, but its 2022 yearly option income was 11.05%. Still, it is very difficult for a consistent call writing strategy to outperform the market itself on a total return basis in the long run, but they can be beneficial to risk-adjusted returns. The benefit seems to be concentrated in writing out-of-the-money calls so the strategy can participate in most of the market’s return. We’ll finish with a common saying regarding options, “Own the probable, sell the improbable.”
