Covered calls help get clients back in equities

Advisors with access to option trading capabilities are finding it easier to get clients invested in equities through the use of covered calls, which mitigate the downside risk on individual stock prices.

Psychologically, clients are much more predisposed to fear of loss than they are to maximizing the potential returns on their investments. This frame of mind makes the covered call a natural sell to clients.

Clients purchase a stock and then write a buy option on the stock at a certain price that is sold on the open market. The buyer of the option has the right to exercise it and the seller has the obligation to sell the stock, if and when assigned by the option holder.

If the stock price never reaches the strike price, the covered call seller makes a nice premium for holding the stock on top of any other dividends or distributions that may be paid out.

If the stock does reach the strike price, the covered call writer misses out on any future returns above and beyond the strike price — ideally, he or she has made a profit on the stock and earned additional income from selling the call.

Charlie Spiring, the CEO of Wellington West, still remains an active top-tier broker servicing clients. He’s been using covered call strategies for 27 years. He points out that the recent market conditions are ideal for covered call writing. He uses both longer long-term equity anticipation securities (LEAPS) and shorter calls based on the outlook for the stocks his clients own.

Back in the fall, Spiring was on a cross-country road show tour for university alumni; he was advocating covered call writing on stocks like Potash, which with a volatile valuation, could offer a higher option pricing.

Using the stock of Potash as an example, Spiring says an investor could have bought 500 shares of the company, at $110 a share, for $55,000. The investor could sell five calls at a 15-month length, for a strike price of $120 a share, for $21.25.

At 500 shares, the call writer would earn about $10,000 back if that stock was to stay level for the next 15 months. If the stock hit the strike price, then the client would make in excess of 30% profit if you include the option writing income.

“The risk in covered call writing is an opportunity risk: you can still make 30% or 40% total return [with a covered call], or you could make 100% without it. Most of my clients, if I make them 30% or 40%, will forgive me because the risk I took was less to do that,” he says. “If I held Potash from its bottom price and held it to its top and made a 125% return, that’s spectacular. Very few people buy at the bottom and sell at the top, and hold the stock through all the gyrations. This allows you to hold things longer. It takes the emotion out and lets time be your friend.”

Spiring’s clients are happy with the return. He says the volatile nature of stock prices in the run-up since March 9, has actually made it more lucrative to sell calls on stocks like Potash.

“Awhile ago we were using 12- to 15-month LEAPS. After March 9, we’ve shortened the term a little bit because the volatility is huge, which gives you the big premium, but you don’t have to use as much time to get the big premium,” he says.

Through an investment counsel, Ted Rechtshaffen, a CFP and CEO of Toronto-based TriDelta, advises some clients to consider using covered calls if they have a predisposition to equity investing and are unhappy with the 1% to 2% returns most fixed income instruments are offering right now.

“If a client wants to earn more than 1% but is an income-focused investor, we would focus more on the preferred shares or corporate bonds. If the client is more of an equity investor, we tell them why don’t we do a half-step into the market — that half-step is where we use cover calls,” he says. “[We equate cover calls] to buying a dividend stock: the dividend stock is going to pay 4%, so at least you’re getting 4% while you’re waiting for valuations to rise. With covered calls, in addition to the dividend, you may be making between 6% to 9%.”

Rechtshaffen says only a full-blown bull market diminishes the appeal of covered call writing.

He’s finding it a valuable strategy for clients who have recently left employers and may have a significant amount of stock in one company they obtained through an employee stock purchase plan. Covered calls can add income to stocks they were likely to sell anyway.

“Writing covered calls will do better than a pure equity investor in bad markets, it will do better than a pure equity investor in a sideways market, and it will do better in a small growth market. However, it will do worse than a pure equity investor in a full-blown growth market,” he says.

Spiring has a similar take. He equates covered call writing to the role of the house in a casino game of chance. People who buy options are taking on considerable risk for a big payout; therefore, the call writer almost always comes out ahead in the transaction.

“When you buy options and speculate, 80% of the time you lose. The flip side of that is when you’re cover writing, you’re making money 80% of the time. The question is, do you want to be the casino or the one speculating?” he says.

Execution tips

Spiring says an experienced broker can make his or her client a lot of money using covered calls, but even a “half-assed” approach can be successful. There are some basic tenets that clients should follow.

The most important aspect is liquidity. You can only sell call options if there is a market for them. That means, most call writing should be done on widely traded large cap stocks.

“You want to get the highly liquid stocks because they’ll trade and the market makers will create liquidity for you or even write special options for you. If you take an illiquid name, the market makers aren’t going to do it for you. You want big recognizable stocks. People should be in the TSX 60 stocks as a good benchmark,” Spiring says.

Volatile or cyclical stocks will tend to attract a higher premium. Of course, the client needs to understand that’s because there is a greater likelihood of the stock price yo-yoing and hitting its strike price.

On the flip side, there is not much of a market for steady performers, such as stock like Enbridge, which has a fairly flat valuations and steady dividend yields, Rechtshaffen says. For more risk-averse clients in the strategy, he says the investment counsel his clients use will put a stop-loss order on the stock.

“Basically, if you’re going to do cover calls, you have to sell the options on shares you must own if the stocks go up. If the stocks go down in price, the covered call is going to be worthless anyway [to the buyer]. You can put a stop-loss, and if the stock hits a certain price, we can sell it,” he says.

Rechtshaffen says he generally uses a strike price that is 5% to 10% higher than its current price to access the necessary liquidity in the market.

Spiring says he utilizes the covered calls on high growth stocks in his own portfolio as a satellite strategy to his core long-term holdings. His company will actually be rolling out a covered call wrap product that includes three of these: Research In Motion (RIM), Potash Corp. and Barrick Gold. The wrap product writes one covered call on all three stocks.

“We’ve done something that combines RIM, Potash and Barrick [as one security]. We found a way to wrap all three together and write an option against it. It’s an even better strategy than holding them on your own. Now you’re diversifying the risk of any one of the three. Those are what I refer to as momentum and high beta stocks,” He says, “[Through the wrap,] you get better deals on the option pricing and a better liquidity.”

(08/07/09)