Strike Price Selection and Management For Portfolio Overwriting


Covered call writing applied to buy and hold positions is generally known as portfolio overwriting. We want to take advantage of premium, upside and dividend capture to leverage our underlying equity positions. Strike price selection is one of the most critical parts to make this strategy work. Let's dig deeper into how we should select our strike prices based on the current market environment and what would make sense in other situations.

Buy-and-Hold Position: Equinix

Interpreting Our VIX Study

The first stock I'd like to discuss is Equinix, the data center REIT, which has shown resilience during the latest stock market crash. The company currently ranks among the best 14% of the entire US stock market given its solid momentum rating and AFFO growth. Fundamentally speaking, this stock is a no-brainer.

Based on the VIX study I conducted (from 2014 - May 2020), buying Equinix in all VIX environments would have generated forward 1-year returns of 23%. Buying the REIT into VIX strength (above 25%) would have produced similar returns, while adding to your Equinix position in low IV circumstances generally doesn't make much sense.

The VIX now stands at 32%, so we can check the green bar: forward 1-year buy-and-hold returns of, on average, 23% are likely, resulting in a 1.9% one-month return.

(Source: Option Generator Research)

We see a similar picture in the Sharpe Ratios; elevated risk/reward if one's buying Equinix in VIX environments of 15%-25%.

(Source: Option Generator Research)

Interpreting the Monthly Technical Chart

Along wit our quantitive analysis, technical analysis is indispensable for long-term investment success. Again, since we're long-term investors clicking the computer for one-month covered call writing monthly charts are the most relevant.

Back in 2011, Equinix shares generated a buy signal based on the MACD, Moving Average and Directional Movement Index. In 2013, the stock hit a temporary high, before breaking out at the end of 2014. That's the signal buy-and-hold investors looking to accumulate were waiting for. For new investors, the breakout represented a first buy signal. In 2018, momentum in Equinix shares cooled, meaning we don't add to our positions or initiate one; we hold onto our existing stake.

In early 2019, shares broke out powerfully, leading to new buy signals. That's the way we should interpret the technical charts as buy-and-hold covered call writers.

Right now, Equinix shares are in bullish chart territory so looking for a bullish covered call strike is appropriate, however, I expect some consolidation between $650 and $680.

(Source: Pro Real Time)

Stocks That Are On The Watchlist But Don't Provide Buy Signals As Of Now

In this market environment full of uncertainty, we have to be rigorous in our buy and hold approach. Roper Technologies, for example, is steadily working its way up to the top of our watchlist, but the technical chart suggests sideways price action over the next year. Should we buy it? Probably not, wait for a MACD up-cross, positive Directional Movement Index and a breakout above $370. Roper is a consistent performer, but waiting for a long-term impulse is appropriate.

(Source: Option Generator Research)

(Source: Pro Real Time)

The same goes for Broadcom, which was added to our watchlist yesterday. Why would we now accumulate a position, despite its strong long-term returns (because of robust free cash flow generation) ?

(Source: Option Generator Research)

(Source: Pro Real Time)

Strike Price Selection

Based on the information provided above, my 'portfolio overwriting script' tells us to favor out-of-the-money covered calls with 2%-3% upside potential for the next one month.

But wait a minute: what if Equinix shoots up to $700, well past our expectations of 2%-3%? In high VIX environments, rolling out and up is as easy as riding a bicycle downhill. This was illustrated in our previous article regarding Market Axess.

Looking at the June contracts for Equinix, we see the following prices appear.

(Source: MarketWatch Options Tab)

Including the upcoming ex-dividend of $2.66, the table below shows up.

(Source: Option Generator Calculators)

Knowing that Equinix generates one-month share price returns of 1.9%, selling the $670 strike (which we currently have in place) leads to a total maximum return of 5.08%. If shares were to go up to $680, leaving that strike $10 in-the-money at expiration, we can easily roll out and up to $690 and still generate a nice credit which lowers our cost-basis even further.

Management Techniques

  • Don't rebalance your covered call writing portfolio, but let your profits run if one stock is outperforming the others. Don't rebalance your strategy diversification if portfolio overwriting is outpacing more defensive strategies.

  • Keep ex-dividend dates in mind and keep an eye on whether your options are deep in-the-money.

  • Don't roll down your call strike prices (especially in high VIX environments when the premiums for every strike are relatively close to each other). Our goal is to generate income, lower our cost-basis and stay non-emotional. The more we adjust/trade, the more headaches we create afterwards. Everything has to start with adding stocks of our long-term winners watchlist to the portfolio that have outstanding technical momentum. Focus on portfolio diversification (correlations).

  • Evaluate the outcome on expiration Friday, unless you have to roll out early because of early assignment risks related to an ex-dividend date.

Don't forget to always keep the following one-liner in mind:

Portfolio overwriting is about staying in the game for the long run, focusing on monthly charts to assess momentum and not getting greedy when looking at the one-month return potential. (Hamish Maertens, May 2020)

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