Index Covered Call (ICC)
Jan. 10, 2013
This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.
Authors note: It is assumed a reader of this information has a working knowledge of options, specifically covered calls. There are many good sources of education for options and covered calls at organizations such as the Option Industry Council and most brokerages will also have an education section on options.
The objective of the Index Covered Call (ICC) portfolio is to consistently capture option premium by selling call options on indexes. The option premium collected can be significant and ideally will enhance total returns. The trade-off for receiving this premium is foregoing some of the speculative upside of a stocks movement. In essence, the covered calls will act as a partial hedge to simply owning the index, and thereby reduce volatility
The net result of the tradeoffs of collecting additional option premium in exchange for the speculative upside of the movement of the index should be an investment that
- In down markets - loses less than simply investing in the underlying
- In sideways market - returns more then simply investing in underlying
- In and up market - makes less than simply investing in the underlying
Those combined results should result in a portfolio that is less volatility than simply owning the index. Over the longer term the compounding of a a less volatile investment has the potential to generate superior returns, especially in markets that do not rise substantially.
This trading plan will compare its performance to three items
- Holding the underlying - ICC's performance vs. the underlying should be consistent with the three results discussed above. Hence, measuring ICC against the underlying is not so much a benchmark of performance but more a way to verify that the assumptions above are actually occurring. If the do not occur than perhaps something is wrong with the underlying logic of the trading plan.
- A 60/40 stock/bond mix of funds (or some other lazy man’s portfolio). Since this is intended to be an alternative investment to traditional portfolio theory it would seem prudent to seeing how it compares to traditional theory.
- An ETF or fund trying to follow a similar concept. In this case PBP. If an investor is able to get better returns from a fund even after paying its expenses, it would probably not be worth the time and risk of managing this strategy ourselves.
Option Selection Overview
The amount of option premium that can be generated is not a static amount and is mostly a function of
- How much upside an investor is willing to sacrifice. An investor has some say in making this decision by which option strike price and expiration they choose to sell.
- How much the investment moves around (volatility) prior to the option expiration date. term. Or perhaps better stated how much the market perceives the investment will move around vs. how much it actually does move around. This is more dictated by market conditions than an investors decisions.
Some examples may help illustrate this situation.
- An investor could chose to write covered calls that expire in the near term that are way out of the money. Using market data as of today for the S&P500, an investor could write a call option with 18 days until expiration, about 5% above the current price and receive about .1% in premium . If an investor repeated this process 24 times a year, the best case scenario is this would enhance returns by 2.4%. However there is less than a 10% chance the investor will miss out on any upside returns from the underlying index.
- An investor could chose to write covered call that are further out in time and near the money. Using market data as of today for the S&P 500, an investor could write a call option expiring with 53 days until expiration about 1% above the current market and receive about 1.7% in premium. If the investor repeated this process about 6 times per year, the best case scenario is this would enhance returns by over 10%. However, there is more than 40% chance the investor will miss out on any upside returns from the underlying index.
- An investor could chose to write covered calls that are very near in time and at or under the current stock price. Using market data as of today for the S&P 500, an investor could write a call option expiring in 3 days for a strike that is just under the current stock price and receive about.9% in premium. An investor could do this 50 times a year receiving over 40% in premium, but with over a 50% chance of loosing money in the appreciation of the underling stock.
As a reader can see, the possible combinations of strike prices and dates is very large. As discussed in the portfolio management section below, the portfolio will follow the general principles in selecting options
- Diversification – as with any investment strategy it is usually worthwhile not to put all your eggs in one basket. Hence, the portfolio will strive to utilize a variety
- time frames (ie. Weekly, monthly)
- strike prices (i.e. atm to slightly OTM).
- Material – Not withstanding the above, this portfolio will select options with the potential for somewhat material annualized gains of at least 8%. Collecting this much premium should be somewhat a given. However, it is important to emphasize that this collection of option premium will be offset by both the performance of the underlying stock and its volatility/trading pattern and is not anticipated to be the total return of the portfolio. In general this portfolio will generate best relative performance in flatish markets
There are three key factors in establish and managing positions in this portfolio.
- Selecting an underlying index or stock,
- selecting a specific option to sell,
- Defining rules/guidelines related to the time and price when the option position should be exited or rolled forward.
This section describes the approach to each area
- Selecting an Underlying
- Liquidity - The most important requirement for an underling to be a candidate for this strategy is liquidity. That means good volume in the underlying and the options. This will generally manifest itself in 1-2 penny wide bid/ask option spreads for near the money options.
- Indexes vs. Individual Stocks – A covered call strategy can be executed against individual stocks, ETFs, futures, and even longer dated options. This portfolio will focus on indexes. Indexes are less volatile than individual stocks, have less noise around individual events such as earnings, and have far less risk of going to zero.
- Price - Generally speaking it would be better to avoid underlings with very low or high prices. For example: if a stock is trading under $10 it may require buying a large number of small priced options usually with large steps between strikes. In this case commissions can become a bigger percentage cost. Conversely for stocks trading for several hundred dollars can require large capital commitments if leverage is not used.T his is because options work only in 100 lot size. So just a single contract covered call in Apple currently requires over $60,000 in capital. In summary, any underlying entity trading between $20 and $200 seems like it could be in the sweet spot for this type of strategy. Most index ETFs will fall in that range.
- Perceived Prospects - The ideal underlying would be one that the investors think is going to grind slowly higher but that the market thinks is more volatile/risky. Admittedly those are somewhat conflicting objective, and hence not easy to find. However, it does mean that this strategy is not well suited to an underlying investors think has good potential to shoot geometrically higher. Other strategies might apply to that type of stock. Conversely, selecting the most conservative index of utility of consumer staples stock will likely not provide much reward because the market already assumes it will grind higher. Netting out all those somewhat conflicting points and it seems the best candidate is not those that an investor think has the best change of going up, but rather the least chance of going down.
- Within the above constraints there are a large variety of types of entities to select from. Some examples include
- Equity indexes - (SPY, QQQ, IWR, EEM, DIA) - most commonly done
- Sector Indexes - (XLF, XLE, XLK, XRT, XHB) - liquidity increasing
- Selecting an Option Date and Strike
- Date - How far out in time to go when selecting an option is a trade off of transaction costs versus larger uncertainties. A few choices
- Monthly - this provides a balance between the trade-offs and seems most often used
- Quarterly - Possible
- Weekly - Weekly options are a new development. However, they seem to be able to boost the amount of option premium collected significantly. Further, doing some weekly options provide a way for investors to more quickly gain experience with how the ICC portfolio reacts and works.
- Strike Price - There seems to be a few common schools of thought on which strike price to choose
- The nearest out of the money. This provides the greatest amount of premium return, but also sacrifices the most upside return, and can create the most churn in the underlying
- A strike with about a ⅓ chance of being hit. Conceptually, that is the option out on the steep slope portion of the normal distribution of potential results and hence yields a good balance between premium generation and minimizing churn. That can easily be approximated by looking at the delta component of the pricing model or is more precisely calculated by most option trading platforms these days.
- A strike a standard deviation away from the current trading price. That works out to about a 16% chance of being hit. The premiums collected will be very small, but the churn should also be small.
- Changing parameters based on other variables - Of course an investor can switch between these various time and price decisions based on other variables. Some examples might be
- If market volatility is low reach further out in time or strike price. Low volatility can be determine based either on a overall easier such as the Vix or based on a comparison of a particular stocks current implied volatility vs historic volatility
- Favoring the possibility of a stock reverting to its mean. If the stock has recently been going up, perhaps the strikes should be a little tighter, with the though that the stock might be over bought, and will consolidate. If the stock has been going down, chose a strike that is a little wider allowing for a potential short-term rebound.
- Closing the position - The mechanics of time and price
- Mechanics - Once a position is taken it needs to be managed (i.e. closed at some point). Overall that is done based on some set of rules around date and price. If the rules are basic, that can be done very pragmatically . However, basic rules may also likely not work well in complex situations which do occur in the real world. Conversely, factoring in many of the complexities of the real world require a lot of human judgment. That judgment can be good or bad. The info below provides some examples of how the situation can be handeled.
- Auto expire. - The simplest way to manage covered calls is to simply let them run until expiration. In essence no management of the position is done. In this case shortly after expiration (perhaps the Tuesday after expiration Friday) One of these two events will have happened and only actions to re-initate the position will be required
- expired - the underlying will not have hit the option strike price (i.e moved sideways or downward) and hence the option will have expire worthless and the full premium collected. . In this case, a new option can be sold a day or two (perhaps on Tuesday after expiration) out in the future based on the date and price rules defined above.
- assigned - the underlying will have hit the option strike price, (i.e. moved up significantly) and the underlying will be called away. In this case, it sets up an ideal review point to determine if investors want to keep or change the underlying investment. Based on that decision a new position established.
While this is the simplest approach, it does not take in to account any other activities that have occurred in the market and.....if it was this easy everyone would be doing it.
- Pre-defined rules about date and time - Many option traders will suggest that it is better to close out the option position when either most of the time has run out of the contract and/or the underlying indexed has moved significantly up or down from the strike price. This is because as these situations occur the option price starts to behave differently than when it was originally sold. Specifically, it will either start to move almost in lock step with the price of the underlying or not to move at all when the the price of the underlying moved. This movement is described in option pricing theory by “the greeks”. This document will not discuss the many aspects of the greeks. However, rules about when to exit a position will be defined by the Greeks, most notably delta as described below.
- If the underlying has moved significantly higher eventually the option will become in the money. As this occurs the delta will increase. When the delta hits 85% the portfolio will look to enter trades to exit the position if the delta continues to rise towards 90. The option will be rolled to be a higher price. In this situation the option trade will be a loss, but the portfolio will have reaped the benefit of a gain in the underlying.
- If the underlying has moved significantly lower, the delta will start to decrease. When then delta gets below 10 the portfolio will look to roll the option to a lower strike price. In this case, the option trade will have returned a majority of its underlying value, but the portfolio will have suffered a loss in the underlying.
- If the underlying has not moved significantly within 5 days of expiration the portfolio will look to roll the option position to a similar strike further out in time. In this situation, due to time decay the option will likely have gained a portionof its potential value.
Risk Management - Diversification and Scaling
The above trading rules apply to a single position. The next question is how to diversify and scale the portfolio. Potential levels of diversification and scaling include:
- More lots of the same underlying. Options work in relationship to 100 shares of stock. The first way to scale is to do more shares. Perhaps 200, 400, 600 shares. One of the advantage of more shares is the ability to split the lot into two different directions.
- More lots of the same underlying with more option strikes. Some diversification can be achieved by buying multiple lots of the underlying and then “layering in” a variety of option strikes based on time frame and price. This creates a laddering effect that provides diversification
- Multiple Underlying - Instead of buying larger lots, investors can choose a handful of underlying. Obviously this provides traditional diversification against one underlying going horribly wrong. Of course if the portfolio is using mostly indexes as a basis there is already a large degree of diversification embedded in the underlying instrument. Hence, the finer the selection of underlying the more likely it is to require more underlying. Further, the options themselves provide some amount of hedged/diversification. Lastly more underlying mean more commissions
Current Index Covered Call Portfolios
Currently, this portfolio will track the following portfolios.
- EEM – Emerging Market ETF - Weekly on Monday, Un-managed (i.e. hold to expiration). Initiate on a Monday by executing a buy/write of EEM and selling one call of with a delta around 40. Do nothing all week. The next Monday if the stock has been assigned then re-establish a similar position. If the option expired worthless sell another call one week out with a delta over 40.. It appears that this approach should be able to generate at least 0.4% weekly in option premium. Doing this 50 times a year would result in collecting 20% option premium. This premium will be offset by any potential losses in the underlying.
- QQQ- Nasdaq 100 ETF – Every two weeks, by rolling calls in the second half of the week. Initiate by executing a buy/write of QQQ which will buy the stock and sell an option for the option out about two weeks. Based on market conditions in about one week later, roll the option to a new option two weeks out with a strike determined based on market conditions.
- IWM – Small Caps – Monthly Options, rolled based on delta. - But 100 shares of this index and sell 1 contract with a delta near 33. These option will be held until the delta reaches either 10 or 80. At which time the option will be rolled to an option with expiration no less than 15 days out with a delta near 33. Normally this will be the next month, but a rapid movement in the index will result in simply changing the strike price in the same month.
- SPY – S&P500 - Monthly options in SPY (S&P 500)managed based on delta - Buy 100 shares of this indexes and sell 1 contract with a delta near 33. These option will be held until the delta reaches either 10 or 80. At which time the option will be rolled to an option with expiration no less than 15 days out. Normally this will be the next month, but a rapid movement in the index will result in simply changing the strike price in the same month. The delta of the new option should once again be about 33.
- XLF – Financial – Quarterly or bi-,monthly options managed, rolled based on delta/amount of money to be gained by a roll. Because this index has a lower price (currently around $16) than most indexes the $1 distance between strikes is fairly wide. To allow time for these larger percentage moves to occur options will be written further out in time. There will be a emphasis on holding options during the time period when many of the large financial institutions create earnings and hence are usually higher volatility months. These include Nov, Feb, May, Aug, Nov. However, it is assumed an option roll to a bridge month in between the quarters will likely be held for a period of time.
CCI will strive to communicate status of these positions and trading notifications via three types of notifications. This utilizes general terms from auctions as basis for description
- Going Once (G1) – The time to act is nearing. An option position is starting to near its defined point for action. No immediate action is required, and if the market reverses perhaps no action will be required for awhile. However, a rapid market move and/or the passing of a few more days of time and it will be time to act on the postion. Hence this is kind of a warning message that action will be forthcoming. If an investor anticipates not being in a position to place a trade with their broker in the near future perhaps now is a good time to get an order in the system.
- Going Twice (G2) – Now is the time to act. CCI has placed an order. It is likely this trade will be filled soon. .
- Gone (Gone) – A trade has been executed.