Covered Call Advice From a Pro

It's a simple-sounding strategy, but it has many moving parts

   

It is widely known that covered calls — or the selling of (out-of-the-money) call options contracts on stocks you already own — is a way to generate extra income. But as with all investment strategies, it is easier said than done, so I decided to seek insight from someone that does it for a living. Expert opinions are always preferable in my book.

Michael Borgen has been with Navellier & Associates in various roles as an analyst and portfolio manager for 17 years, and in 2009 he was challenged to run an institutional covered call portfolio. I spoke with him about the covered call strategy and discovered that the investment business is just like going to a doctor or a lawyer — you always get a little different take on how to approach the same matter.

“Some covered call portfolios today are run by selling close-to-expiration call options one month out and constantly rolling them every month,” Borgen says. Through experience, Borgen found out that it is more efficient to sell call options six months out (even nine months in some cases), then tweak the strategy if necessary.

“For example, if I am shorting 210 calls of a stock six months out, and the options go into the money before they expire, I might sell the in-the-money calls and short some that are further out of the money,” Borgen says. This is because the stock will be called away in most cases, and instead of surrendering the shares and buying them back again, he can avoid all that hassle and concentrate on harvesting the premiums on out-of-the money calls in the portfolio.

The covered call strategy sounds simple, but it turns out that there is more to it than just running a regular equity portfolio.

“There are more moving parts,” Borgen says. “There are the stocks, there are the options with different strikes and different expiration — you have to follow all at the same time.”

You would think that stocks with expensive options — with higher implied volatility priced into the call contracts — would be the best for a covered call strategy, but it turns out that it is exactly the opposite. (Implied volatility is what the market estimates the volatility of the stock will be in the future, where historical volatility statistically is what has happened over the last, say, 10, 30 or 60 days. The two are different and cannot be arbitraged, even though historical volatility clearly affects implied volatility as traders estimate the likely outcomes.)

“My No. 1 goal is capital preservation, then extra income, then growth,” Borgen says.

That leads Borgen to “marquee names” as he calls them, with liquid options that allow for the most efficient running of a covered call strategy. It also turns out that the Dow Jones Industrial Average is perfect for that, as his top holdings indicate:

1. International Business Machines (NYSE:IBM)
2. Home Depot (NYSE:HD)
3. Caterpillar (NYSE:CAT)
4. Chevron (NYSE:CVX)
5. Union Pacific (NYSE:UNP)
6. American Express (NYSE:AXP)
7. McDonald’s (NYSE:MCD)
8. Exxon Mobil (NYSE:XOM)
9. Wal-Mart (NYSE:WMT)
10. Intel (NASDAQ:INTC)

Curiously, there are very few financials in this strategy, even Dow names. There is American Express, but this is a consumer-oriented financial company lacking the balance sheet games that got the country’s biggest banks in trouble.

“I want to shoot for 6%-12% option premium yield on an annualized basis, of course it all depends on the market environment,” Borgen says. “In investing, there are no guarantees. Last summer, the S&P 500 Volatility Index was at 48. Now it is at 16. So options are way cheaper, and you tend to get much lower option premium yield.

“Even though the VIX measures how expensive index options are, the implied volatilities of many stocks are heavily correlated to the VIX.” (The CBOE has calculated single-stock VIX indices for Apple (NASDAQ:AAPL) and IBM that demonstrate Michael’s point well.)

“Forget financials” that have expensive options — Goldman Sachs (NYSE:GS) is a good example here — they typically are too problematic to fit the capital preservation objective that is the most important. “Even good stocks like AutoZone (NYSE:AZO) and Apple don’t fit a covered call strategy. They move faster than most large caps and there will be a lot of roll-ups of call contracts — the more trading around call contracts one does, the more expensive it will be as bid/ask spreads will eat into the income generated by the sale of the options.”

One good thing that has come from the evolution of the options market, Borgen says, is the constantly increasing volume. Options are becoming popular with individual and institutional investors, and this brings down bid/ask spreads and allows for more money to stay with the investor as opposed to the market maker. Still, this is a conservative strategy that targets low-risk yield enhancement on top of the generally higher-than-S&P dividend yield of the portfolio, currently at 2.6%.

“One big mistake retail investors make is trading naked options, while most professionals trade spreads and hedge their bets,” Borgen says. “I don’t even go that far. I trade only covered calls, which is less risky than spread trading. It is possible to be conservative in the options market and sleep well at night; it’s called covered calls.”

Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions for its clients in all stocks mentioned in the article, except for Goldman Sachs. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities


Article printed from InvestorPlace Media, http://investorplace.com/2012/04/covered-call-advice-from-a-pro/.

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