Why your stockbroker loves covered calls…
posted on October 31st, 2013 by David
Covered calls or buy-writes are a popular investment strategy that allow investors to both reduce volatility and increase returns on their share portfolio over the long-term. Now before I continue, this isn’t another “introduction to covered calls” article – there are already plenty of good ones, here, here and here. Nor is it a post to try to convince you of their merit – this has been done and the results are conclusive. Instead, in this post, I’d like to identify and outline one of the pitfalls that most investors give little thought to – fees and in particular paying a “full-service” stockbroker. If you’re already using covered calls with a stockbroker or considering it, read on…
Most stockbrokers get paid when a transaction occurs and typically their brokerage is a function of the total value of the trade. For example, if you phone your stockbroker and ask to sell $50,000 worth of BHP shares your stockbroker will happily oblige and then charge you $500 (assuming you pay 1% which is typical with full-service brokers). The stockbroker is generally paid on commission and will receive a share of that $500, so it doesn’t take a genius to figure out that if this is the case then he or she is incentivised to encourage transactions.
Now to sidestep for a moment. Writing covered calls over a stock comes with the obligation that if the stock rallies there is the real likelihood that the buyer of the options will choose to exercise and you will be forced to sell your shares. This key attribute of covered calls (the necessity of selling stock if exercised, plus buying it back to write options the following month) is precisely why covered calls are a favourite strategy of stockbrokers – they literally get paid every time you buy and sell stock. To really highlight this idea and its impact let’s examine some numbers.
Assume for a moment that you hold $100,000 worth of shares in XYZ company. In order to generate some additional income and enhance your returns you agree to implement covered calls over the shareholding and begin selling call options each month. Some months the options expire worthless, leaving you with the premium and your original shareholdings and in other months, the stock rallies and you are obligated to sell your shares and buy them back to continue the strategy the following month. If your shares are exercised every second month and let’s say your stockbroker only charges you 0.5% (you are after all, a valuable customer!) you will end up paying him $6000 for the year or 6% of your portfolio value. In other words your yearly return will be 6% lower because of the fees you pay. With regular transactions and high fees no wonder stockbrokers love covered calls!
Fortunately these days we don’t have to rely on full-service stockbrokers as the internet has made the buying and selling of shares and options as simple as a few clicks of the mouse. Instead of paying a stockbroker 1%, online brokers allow you to trade at rates of as low as 0.1%. Of course, simply being able to buy or sell at low rates only solves one part of the problem, knowing how and when to implement a strategy such as covered calls is the other and arguably the more important component.
Is it possible to successfully run a covered calls strategy and avoid paying your stockbroker outrageous fees? The answer turns out to be yes and there are three ways to go about it.
1. Educate yourself.
2. Negotiate with your existing stockbroker.
3. Find someone with a different approach.
The simplest way to gain the knowledge required to implement an investment strategy like covered calls is to educate yourself. Don’t be daunted by terms like, Black-Scholes or butterfly spread (and that’s only the B’s!). Every speciality has its own jargon and it turns out that these terms aren’t all that complex. You probably use terminology in your own profession that would intimidate someone unfamiliar with that industry too.
Being informed and becoming the ‘expert’ is the best way to avoid being forced to use their services and therefore avoid paying the huge associated fees but it does come with a time commitment getting up to speed and a small ongoing undertaking on your part.
Good luck! Stockbrokers like any professional charge for their services. Unless you have tens of millions in an account with your stockbroker it is unlikely you will be able to negotiate anything even close to the rates of an online broker. If you push too far you might find yourself being told to take a hike, very politely of course!
Before I begin it’s important to disclose that I co-founded and manage Bellmont Securities, an investment manager / broker that I will mention shortly.
It’s true not all stockbrokers or investment managers are the same. At Bellmont Securities we manage covered calls a little differently. For starters we don’t charge the traditional brokerage rates found at most stockbrokers and instead charge a yearly management fee of 0.5% plus 20% of any outperformance generated over and above the portfolio’s performance before using covered calls. This means that other than the annual management fee – which is less what you would pay for a single transaction at a traditional stockbroker – you only pay us if we generate performance above what your portfolio would have returned before we became involved. For us to get paid we must be adding value. Makes sense right?
Another way to approach covered calls is to use index options instead of individual options. This approach has a number of benefits which I have written about here. Chiefly, Index options are cash settled, removed the necessity of selling your shares if exercised. With no selling and subsequent re-purchasing each month is it of any surprise your stockbroker hasn’t told you about this?
1. Covered Calls are a great strategy that can be used to reduce volatility and increase the returns over the longer term.
2. If you use a traditional stockbroker you will be shocked at how expensive implementing covered calls can be.
3. There are two effective ways to reduce your fees, either educate yourself and commit to managing it or find an investment manager who takes a different approach.