Covered-Call Writing and Finding the Right Underlying

Introduction

Of all option strategies, covered-call writing is considered to be least risky one. However, not every stock/underlying fits the bill. Thoroughly analyzing drawdown graphs, probability of profit and Sharpe Ratio should be a no-brainer before thinking about dipping your toe in the water. Let's consider Dollar General (DG), probably the best retailers in the world, and Broadcom (AVGO), a key player in the semiconductor industry. At the end of this article, we're going to share the backtesting results for monthly covered-call writing on 5 US stocks and how their cumulative performance stacks up against holding the SPY tracker.


Backtesting on AVGO

Since 2010, selling covered calls on AVGO or holding stock outright has yielded attractive returns (about 28% annually excluding dividend distributions). However, as can be seen from the graph below, from 2018 onwards both strategies have started to exhibit increasingly volatile results. While it is correct that covered-call writing managed to close the return gap earlier this year, this option strategy isn't going to beat the buy-and-hold performance in very bullish market environments.

(Source: Option Generator Research)


Looking at the drawdown chart below, we notice the steep declines regardless of whether or not you had been continuously selling a covered call since June 2010. During a parabolic rally and the subsequent pullback the covered-call strategy actually lost more than the buy-and-hold approach in 2015... That's the main reason why we sold out our tech stocks which we have been selling covered calls against for quite some time. It's just not a smart move to chase an ever increasing share price with covered-calls. Long story short, the aftermath will be disappointing.

(Source: Option Generator Research)


Although 72% of the months were profitable for a covered-call strategy w/o rolling down the strikes during corrections, the final outcome when selling covered calls against a very volatile stock yielded poor returns. A higher chance of facing a steeper drawdown of 10+% makes it difficult to continuously execute the option strategy. As such, the risk-adjusted return advantage is not worth it.

(Source: Option Generator Research)


Backtesting on Dollar General

Turning now to Dollar General, we clearly see the added value of selling calls against a long stock position. The covered call strategy generated a total return of 22% with 15.3% in standard deviation, versus 20% and 23% respectively for the buy-and-hold investor. Since 2018 about 85% of the months have been profitable for the covered-call strategy which doesn't roll down the strikes during corrections. Based on our extensive backtesting and research, chasing the stock down and up produces extremely mediocre returns from both an absolute as well as risk-adjusted return standpoint.

(Source: Option Generator Research)


Looking at the drawdowns for a covered-call strategy on DG, they tend to be a lot smaller than the SPY's. A higher probability of profit with fewer drawdowns makes it easier to ride challenging times out. Adding Dollar General's outperformance during economic recessions to the equation, there's little doubt this stock is a great underlying for a conservative covered-call strategy.

(Source: Option Generator Research)


5 Defensive Stocks We Recommend Utilizing For Monthly Covered Calls

In the next weekend video update for our premium members, we're going to highlight 5 liquid stocks (including Dollar General) that have proven to be excellent vehicles for monthly covered-call writing. Most importantly, they continue to thrive in this market environment. Over the past decade, these stocks would have generated a total return (including dividends) in excess of 20% with 12% annual standard deviation. To put some context around those two numbers, the S&P-500 yielded a total return of approximately 12% with 17.4% standard deviation.

(Source: Option Generator Research)

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