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The Most Popular Basic Hedging Strategy: Covered Call Writing

In the world of options, there are three basic hedging strategies:

  • Buying a call
  • Buying a put
  • Selling a covered call, also known as covered call writing (CCW)

The first strategy profits from an increase in price of the underlying asset; the second profits from a decrease in price of the underlying asset; and the third profits above all, but not only, from price stability of the underlying asset. Chart 1 shows the return of two indices between 2005 and 2010. The black line represents the S&P 500, the main U.S. stock index, whose symbol is SP500; however, according to the data provider, the symbol of this index is sometimes ^GSPC, $SPX or INX. The yellow line represents the BXM Index, i.e. the BuyWrite CBOE S&P 500 Index. The BXM replicates the covered call writing strategy, because it uses as the underlying asset the S&P 500 Index and options on this index. It was created in 2002 by the Chicago Board Options Exchange (CBOE), the first options exchange1.

The CBOE was founded in Chicago in 1973, one year before the Montreal Stock Exchange became the second in the world to launch an options market on Canadian securities.

Chart 1 – Return of the S&P 500 and BXM indices from 2005 to 2010

The BXM is an index based on the passive return of the covered call writing strategy. The strategy upon which this index is based involves the following transactions:

  1. Buy a portfolio composed of all the stocks in the S&P 500 Index.
  2. Write calls (on this index) with the closest expiration date and a strike price closest to but above the price of the underlying asset (these options are therefore slightly out of the money). This transaction takes place on the third Friday of the month, which is both the expiration date of options for the current month (on North American markets) and the date on which investors implement their options strategy for options that expire the following month. These options will therefore exist for approximately four weeks, which means that options expire each month of the year.

The BXM strategy is called “passive” because it is repeated on the third Friday of each month, without changing anything in the interim. The premium generated by the call writing is added to the value of the stock portfolio. The covered call writing position is maintained until the expiration of the calls, at which time a new covered call is written (one that is the least out of the money) which will expire in one month. An investor who wants to use the same strategy with similar tools should buy the S&P 500 Index in the form of an exchange traded fund (ETF), like SPY (see Chart 2).

Chart 2 – SPY, the ETF that replicates the S&P 500 Index

At the same time, the investor should write covered calls on SPY, which trades on the CBOE. For example, with SPY at $107.96, one-month calls whose strike price is $108.00 (just slightly out of the money) sell for $3.15 each.

Possible scenarios at the expiration of the options2. The underlying security remains unchanged – or almost – at the expiration of the call

If SPY is at $108 on the day on which the call expires (the third Friday of the month), the call is worthless and the writer pockets the premium of $3.15. To this is added the difference in the price of SPY of $0.04 per share ($108 - $107.96). In this case, the strategy will have produced a return of 2.95% in one month [($3.15 + $0.04) / $107.96].

The underlying security is down at the expiration of the call. The strategy serves as a partial hedge if SPY drops, because the $3.15 premium earned offsets a decline of similar value in the ETF. Consequently, the breakeven point for the underlying asset falls to $104.81 ($107.96 – $3.15), which means that the ETF can drop to this price without incurring any loss. Of course, if it falls below $104.81, the investor is in the red.

The underlying security is up at the expiration of the call. If SPY is above $108 on the day on which the call expires, the gain is limited to $3.19 ($3.15 + $0.04). The call will be exercised and the call writer will have to deliver the shares at $108, even if the stock is at a higher price. So the profit with this strategy is limited to $3.19 per share, i.e. a return of 2.95% in one month, which is still not bad at all!

Chart 1 illustrates the strengths and weaknesses of this strategy. When the S&P 500 registers rapid gains, the BXM does not offer a higher return: from 2005 to 2008, when the market had rapid upswings, the return of the BXM was often lower than that of the S&P 500. Conversely, when there is a steady rise in the index, or when the market is flat or down, the BXM returns more than the S&P 500, or loses less.. So this strategy reduces return volatility, an advantage that any investor should appreciate. Since volatility is a measure of the risk level of an investment, the lower the risk, the better the chances of a good return. The covered call writing strategy is suitable for any stock on which options are traded. Because of the popularity of this strategy, the Montréal Exchange offers a calculator which shows the return obtained with this strategy for each stock on which there are options.

The indicated rates of return do not take into account the transaction fees that would have reduced returns.

Chart 3 – Research in Motion (RIM)

For example, RIM (Chart 3) offers the potential profit and return shown in Figure 1, which is excerpted from the page dedicated to this strategy on the Montréal Exchange website (www.m-x.ca).

Figure 1 – Covered Call Calculator

Source: Montréal Exchange, www.m-x.ca.

Applying the BXM rules, an investor buys shares of Research In Motion at $55.23 each (we are in July). At the same time, the investor writes the August/$56 call at $2.20 per share.  It takes 100 shares of RIM to cover one call, because the call assumes a lot of 100 shares. So the investor disburses $5.523 for each lot of 100 shares of RIM and is credited $220 for each call written.

On the third Friday of August, three scenarios are possible

RIM is at $56, i.e. the call strike price

The call is now worthless. The investor pockets the premium, i.e. $2.20 per share. In addition, the stock gained $0.77 per share ($56 – $55.23), which represents a total profit of $2.97 per share, i.e. 5.38% in one month ($2.97 / $55.23). The investor keeps his/her shares, unless another investor wants to exercise his/her option in order to pocket a dividend. The probability of this happening is very slight, but it does exist. The money pocketed from the sale of the shares at $56 each will enable the investor to buy another 100 shares and to repeat this strategy with the September call, and so on and so forth.

RIM is below $55.23, i.e. the share purchase price

The call is now worthless. The investor pockets the premium, i.e. $2.20 per share. The breakeven point has fallen to $53.03. If the stock falls below this price, the investor loses on the stock. The investor must then decide what to do: hold on to the stock, if he/she believes it will go back up, sell it, or place a stop loss order.

RIM is above $56, i.e. above the strike price.

The investor exercises his/her option and must sell the shares at the strike price ($56). The investor's profit will be $2.97 per share: the difference between the strike price and the purchase price ($0.77) plus the option premium ($2.20). This represents a return of 5.38% in one month, which is still a very attractive return3.

When options were created in 1973, the covered call writing strategy quickly gained popularity, but at the time all options had a three-month expiration. It was the covered call writing strategy that prompted stock exchanges to offer options that expire every month. But why does this strategy use options that expire at the end of one month rather than after three or six months, for example? One reason is the very nature of the options: the decrease in premium value accelerates significantly as the expiration date approaches. Consequently, an option that expires in three or six month keeps its value longer, which could slow or complicate the profitability of this strategy4.

1 The CBOE was founded in Chicago in 1973, one year before the Montreal Stock Exchange became the second in the world to launch an options market on Canadian securities.

2 The indicated rates of return do not take into account the transaction fees that would have reduced returns.

3 It would be interesting to know the probability that at the end of one month, a stock will reach, for example, a level above the strike price of a given option. For this purpose, one can use the probability calculator available at http://www.optionstrategist.com/free/analysis/calcs/probability/index.html, the site of Lawrence G. McMillan, the author of a book on option strategy basics whose first edition dates back to the late 1970s. Note, however, that the probability is based on an equal theoretical possibility that the stock will rise or fall, and it does not take into account the current trend, which is a serious shortcoming. The probability calculator requires that the historical volatility of the stock be specified. For Canadian stocks, this data can be found on the Montréal Exchange site, on the page that shows the series of options for each stock.

4 Investors can learn more about this subject by studying an option’s theta, which measures the rate of decline in the premium due to the passage of time.

The present document is provided for information purposes only and is intended for sophisticated investors whom have extensive experience in trading options. Investors should review the document that describes the risks inherent in negotiating options «Regulatory disclosures and information on asset protection». Options are not suitable for all type of investors.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).