Covered Calls using Index Options – A Path Less Travelled

posted on April 24th, 2013 by David

photoMany investors who travel the well worn path of self-education sooner or later come across “covered calls”. Very few however look past their most basic form…

In this post, I outline an alternative approach that despite being rarely used, has solid academic research behind it and offers some surprising advantages.  Best of all, it’s a strategy that most DIY investors who are familiar with covered calls can implement themselves!

The Basic Form Covered With Individual Options

A covered call, also known as a buy-write, is a relatively simple investment strategy where the basic form involves buying shares and selling call options using the same underlying stock.  The strategy generates income, provides a cushion against a fall in the price of the share, but does however cap the maximum potential gain in that particular period.  The investor therefore is effectively exchanging upside for certain income and reduced volatility.  There is little wonder why it has become so popular amongst DIY investors.

An investor who chooses to use covered calls faces a number of constraints, two of which I will explain now.  Firstly, it is essential that there exists a direct relationship between the share price and the call option.  It is absolutely necessary, that the investor sell options for the same underlying shares as she has previously bought.  For example, if she buys BHP shares she must also sell BHP options.

A second constraint investors face when looking to implement basic form covered calls is that they are limited to those shares that have options listed by the ASX.  At first glance the list looks impressive and stands at around 85 but further examination reveals, that due to poor liquidity, the effective list is closer to 25.  This means that almost 88% of stocks in the ASX 200 simply cannot be used with this strategy!

In summary, the basic form covered call is created by buying shares and selling the same underlying options from a universe of around 25 stocks.  Now to a slightly different topic, but stick with me as it’s going to segue rather nicely…

Using Index Options

Anyone who has been involved in the market for any length of time has probably come across the ASX 200, which is simply a weighted index of the largest 200 shares listed on the exchange.  Also called the XJO, the index is used to track the overall trend of the market as it takes into account a weighted movement of each stock.  The index itself isn’t tradable but it turns out that there is a very liquid options market available and the prices of those options are directly related to the top 200 constituent companies.

The astute reader may recognise that although the XJO cannot be bought, in theory, if all 200 companies were held an XJO call option could be sold and a covered call would be created.  The stocks would have to be purchased using the same weightings as the XJO and would have to be rebalanced from time to time but in theory it could be done.  From a practical standpoint however it would be impossible or at the very least cost prohibitive as most investors do not have the resources to buy 200 stocks, plus the brokerage costs would be horrendous, more than wiping out the benefits of the strategy.

A moment ago I stated that it was “absolutely necessary, that the investor sell options for the same underlying shares as she has previously bought”.  Whilst this is true for the basic form covered call, it does not necessarily hold in general.  What’s actually important is the relationship between the underlying asset and the sold options.  Or more simply, the price of the call option needs to be highly correlated with the bought asset.  If the XJO isn’t tradable and buying 200 companies is out of the question, is there any way we could use the highly liquid XJO options market with a covered calls strategy?  The answer is yes.

It is possible to construct a small portfolio of listed companies that have a very high correlation to the index itself, so much so that they could be used as a substitute for the index.  For example this financial year the ASX 20 (an index comprised of 20 companies) currently has a beta of 1.017 (measured daily as at 10th April 2013).  Whilst a discussion of beta is beyond the scope of this post, a measure of 1.017 demonstrates the very high correlation between the two.  This is illustrated beautifully from the below chart which shows the movement of the two over the last 6 months.  Notice how they almost perfectly follow each other.

continued from previous column…

ASX 20 VS ASX 200 – Oct 2012 – Apr 2013 – Source Google Finance

It’s possible to create another portfolio outside the top 20 which has a similar correlation to the XJO.  The ASX 20 was simply used as an example and in practice you would construct a suitable portfolio using almost any of the top 200 companies.

With some creative thinking we have been able to create a portfolio which contains a manageable number of stocks and has a high correlation to the XJO.  This means we could in essence create a covered call by buying those stocks and selling an XJO Index option.  For those of you following closely, we have overcome the original constraints of the basic form covered call ie: having to buy the same underlying asset as the option and massively expanding our investment universe!

Why Else Would You Want to Use Index Options Rather Than Individual Options?

Overcoming those first two constraints is great but there are plenty of other reasons to use index options to build a buy-write.

  1. Cash settlement – Index options unlike individual options are cash settled.  This means if we are exercised (ie: the index closes higher than the sold strike on expiry) then we simply transfer cash to settle the difference.  Index options have a multiplier of $10 so for example if we had sold a single option and it settled 50 points in the money we would transfer $500 and maintain our stocks.
  2. Transaction costs – Given that our option is cash settled and we are not forced to sell and then repurchase our shares this strategy enjoys far lower transaction costs than the basic form.  Also because we use a single option rather than one for each stock holding we reduce costs here too.  Every dollar saved on transaction costs increases our return.
  3. Capital gains benefits – Again the feature of cash settlement which causes us to hold on to our stocks for longer means we are more likely to hold them for the minimum 12 month period to be eligible for the capital gains tax discount.
  4. Liquidity of options – As previously alluded to the XJO options market is highly liquid and has almost doubled in the last three years.  The high levels of liquidity mean we have plenty choice regarding which strike to select and the spreads tend to be tighter again reducing our costs.
  5. Diversification – Given that the index option is priced on the ASX 200 the strategy actually requires the investor to be diversified which reduces stock specific risk.

SIRCA Research

Despite index options being rarely used by investors – at least in Australia – there has been a very substantial study conducted by SIRCA.  SIRCA is the regions leading independent financial services research hub and was founded by 25 collaborating universities.  It is highly respected and generates some outstanding research.  The paper titled “Return and Risk of Buy-Write Strategies using Index Options” is publicly available and examines an index based buy-write in the Australian context over 15 years between 1987 – 2002.  It concludes

“…that the buy-write strategy generates a higher return than the index portfolio, and the standard deviation of returns on the buy-write portfolio is less than the standard deviation of returns on the index portfolio. On both a total risk and beta-risk adjusted basis, the buy-write strategy outperforms the index portfolio…”

Of course any returns generated in the past are not necessarily replicable today, they are reassuring to have.

A Final Word of Warning

Although previously alluded to, one of the fundamental requirements of constructing a covered call or buy-write is to ensure that is there is a strong correlation between the underlying asset at the sold call options.  This is paramount and investors must be vigilant in monitoring this as failure to do so results in increased risk.

Written by David Montuoro – Director, Bellmont Securities.

Special thanks to Bellmont Securities intern Sam Campbell for research.


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