10-Year Study on Equinix: Does Covered Call Writing Really Work?

Introduction

At Option Generator, all information pieces that we provide to our premium members or readers in general should be relevant. Given the coronavirus uncertainty, we received a lot of questions regarding the performance of covered call writing in a long-term stock portfolio.


Does covered call writing really work in the long run on individual equities like Equinix? We just finalized a study, going back 10 years worth of data to evaluate the returns of continuously selling one-month covered calls and rolling them out (and up) at the end of the contract period.


In this article, we'd like to present the results about 3 scenarios: selling moderately bullish out-of-the-money covered calls (3.8%, on average, above the share price, continuously adjusting the strike on a one-month basis at expiration); at-the-money covered calls (1.8%, on average, above the share price) and bullish out-of-the-money covered calls (6.9%, on average, above the share price). The study does not include dividends. The implied volatility for 30-day calls is presented below.

(Source: Option Generator Research)


1) Moderately Bullish Covered Calls

Strike prices

Let's start off by looking at the base scenario: being moderately bullish and reviewing the strike prices on a monthly basis, making sure that we're always out-of-the-money. Below you see the difference between the strike price and the share price at the time each option was sold.

(Source: Option Generator Research)


Visualizing the share price evolution of Equinix since June 2010, the strike prices are shown in the red line.

(Source: Option Generator Research)


1-Month Returns

As one would have expected, the covered call writing strategy returns tend to cluster around -5% and +5%, whereas outlier moves in the share price are more frequent. The question remains: how does the cumulative performance look like?

(Source: Option Generator Research)


Cumulative Performance

At the end of March 2020, the covered call writing strategy would have outperformed the buy and hold investor by 83%. Nonetheless, given the strong rebound of Equinix shares over the course of April, the absolute outperformance has decreased to 32%. Because of high implied volatility and consolidation in Equinix shares, the covered call writer is expected to widen his outperformance gap.

(Source: Option Generator Research)

(Source: Option Generator Research)

Drawdown Graph

The Drawdowns chart maps every single portfolio loss from any high point along the way. It is utilized to study just how low a certain asset allocation has fallen, how long it has taken to recover, and generally how prepared you are both emotionally and financially to handle the downside risks with your own life savings. Stated differently, how frequently does the asset set new highs, i.e. showing no drawdown (curve at 0%).


As for the covered call writing strategy, the drawdowns (32 in total) are considerably lower than those of the buy and hold strategy. The covered call strategy also frequently sets new highs. For example from September 2011 up until June 2012, this covered call strategy didn't suffer from a drawdown, whereas the Equinix shareholder faced a 3% decline in December 2011.

(Source: Option Generator Research)


% Positive Periods

Covered call writing increases the probability of profit as shown below. Fewer negative periods (and fewer drawdowns exceeding the 10% threshold) but no positive outlier moves (at least for this particular strike price selection). Covered call writing requires a disciplined approach, because it leads to lower risk. Is that a correct assumption?

(Source: Option Generator Research)


Overall Picture

Selling covered calls on Equinix since 2010 has proven to be lucrative, but what about the risk? The standard deviation in Equinix' monthly buy-and-hold returns was 32.6% higher than the volatility in the covered call writing returns. All in all, capturing 105.6% of the buy and hold return with 32.6% less risk.


2) At-The-Money Covered Calls

Strike prices

Let's do the same study on at-the-money covered calls that see a higher INITIAL premium with little or no upside potential. Below you see the difference between the strike price and the share price at the time each option was sold.

(Source: Option Generator Research)

(Source: Option Generator Research)


1-Month Returns

Compared to the moderately bullish covered call strategy, selling at-the-money covered calls translates into a slightly lower standard deviation (thus fewer outlier moves to both the down- and upside).

(Source: Option Generator Research)


Cumulative Performance

At the end of April 2020, the covered call writing strategy would have underperformed the buy and hold investor by 68%. As can be seen from the graph (in the return differential section), the at-the-money covered call generated significant alpha from 2013 to June 2015 because of Equinix' steadily rising share price.

(Source: Option Generator Research)

(Source: Option Generator Research)


Drawdown Graph

Selling at-the-money covered calls results in fewer drawdowns; namely 27 occurrences for the covered call write compared to 46 for buy and hold investors.

(Source: Option Generator Research)


% Positive Periods

The number of positive periods increases for at-the-money covered calls, as we generate a higher initial premium.

(Source: Option Generator Research)


Overall Picture

Selling at-the-money covered calls on Equinix since 2010 has proven to be lucrative, but what about the risk? The standard deviation in Equinix' monthly buy-and-hold returns was 40.7% higher than the volatility in the covered call writing returns. All in all, generating 89% of the buy and hold returns with 40.7% less risk.


3) Really Bullish Out-Of-The-Money Covered Calls

Strike Prices

The last covered call strategy presented in this article is about out-of-the-money covered calls that are 6.9% out-of-the-money (on average). Let's see what's in the cards for this investment approach.

(Source: Option Generator Research)

(Source: Option Generator Research)


1-Month Returns

Compared to the moderately bullish covered call strategy, selling far out-of-the-money covered calls translates into more standard deviation (thus more outlier moves to both the down- and upside).

(Source: Option Generator Research)


Cumulative Performance

During the bull market in Equinix' share price, selling premium (i.e. covered call writing) would have generated superior returns. Since 2015, the outperformance gap widened noticeably and given Equinix' favorable business momentum, that trend should continue.

(Source: Option Generator Research)

(Source: Option Generator Research)


Drawdown Graph

As we're generating less premium for an out-of-the-money covered call than we would have with an at-the-money option, the number of drawdown occurrences rises to 40.

(Source: Option Generator Research)


% Positive Periods

Along with smaller options credits, outlier moves show up more frequently.

(Source: Option Generator Research)


Overall Picture

Selling far out-of-the-money covered calls on Equinix since 2010 has proven to be extremely lucrative, but what about the risk? The standard deviation in Equinix' monthly buy-and-hold returns was 23.2% higher than the volatility in the covered call writing returns. All in all, generating 117% of the buy and hold returns with 23.2% less risk.


Final Conclusions

For Equinix, selling covered calls that are between 3.8% and 6.9% out-of-the-money has produced impressive results from both a risk-adjusted and absolute return perspective. If the share price of Equinix goes up or down, the strike price is set to be adjusted accordingly to meet this criterium. The study didn't take into account the fact that after a correction it's possible to experience one-month recoveries of 15+% (as was the case during the Covid-19 stock market crash). This article showed you that by being mechanical and following the script, covered call writing on elite performers like Equinix provides attractive long-term returns. It's up to each individual investor to assess the risk/reward profile of the three strategies discussed above.

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