Buy-write looks to be a good call in volatile times

INCREASED market volatility and risk constraints are changing the way modern investment portfolios are being managed.

This is particularly the case for money managers and investors seeking to generate income from, or reduce the downside price risks of, their investment portfolios.

In light of ongoing market uncertainty, there has been growing demand for financial derivatives (e.g. options) and income/portfolio hedging strategies (e.g. covered calls, credit spreads, protective puts) in the Australian retail investment environment.

Covered call writing (or “buy-write”) is an example of a popular options-based strategy used in flat or sideways trending markets.

The covered call is essentially used as a “buy and hold” strategy, whereby a stock is purchased and a short-dated (i.e. one-month) call option contract on the stock is simultaneously written to generate income and capture limited upside price appreciation.

The strategy essentially produces income through the collection of sold call options and converts the prospects of uncertain future capital gains into immediate cash flows.

It also reduces the average cost of acquiring the stock and offers defined pay-offs.

The asset pricing literature provides evidence the strategy is effective in lowering overall portfolio volatility.

Although the income generated from call writing provides partial protection against small declines in the stock price, it also creates an opportunity cost. For instance, call writing caps profits due to the writer’s obligation to sell at the contracted exercise (or strike) price and expiry date.

The merit of the strategy is therefore compromised when markets rise rapidly as the investor is not able to fully participate in strong upward movements of the stock price.

So does the covered call add value for investors?

In a recent study, I examined the performance of monthly covered call option strategies using a blue-chip Australian equity portfolio from 2010 to 2015.

It showed that covered call writing produced similar returns at lower risk when compared with the stand-alone buy-and-hold portfolio, and that market volatility seemed to be a significant driver of covered call writing performance in Australia.

Overall, covered call strategies based on blue-chip stock portfolios appear to create value for fund managers and investors in the Australian stock market. However, further research is needed.

COVERED CALL WRITING PRODUCED SIMILAR RETURNS AT LOWER RISK WHEN COMPARED WITH THE STAND-ALONE BUY-ANDHOLD PORTFOLIO

DR SCOTT NIBLOCK IS A LECTURER AT THE SCHOOL OF BUSINESS AND TOURISM AT SOUTHERN CROSS UNIVERSITY