This Option Strategy Can Be Your Bond-Replacement Vehicle

Introduction

When it comes to risk management, investors should look at both correlation and beta to gauge the impact of price changes on their portfolio. Also, we want to diversify across many stocks and industries to eliminate excess risk while maintaining our return objective.


However, traditional investment strategies mistakenly rely on the same products to reduce risk: bonds and stocks. Although bonds (7-10y US treasuries) and stocks (SPY) have been negatively correlated with each other for most part of the past decade, the relationship between those two products is far from static as is the beta (-0.1628).

(Source: Option Generator's Research)


Hence, buying bonds and stocks won't be as effective as it has been over the past decade (due to lower interest rates).

(Source: Option Generator's Research)


Here's where covered option strategies come into play. In this article, we're going to take a look at 1-year in-the-money covered call writing on 3 different stocks, namely Johnson & Johnson (JNJ), American Tower (AMT) and Salesforce (CRM). All three stocks are on our long-term watchlist. They've had an average implied volatility of 14.4%, 20.5% and 34.9% respectively since June 2010.


Why do we want to exhibit the ITM covered-call returns? Because this defensive options strategy allows us to immediately compute the outcomes for any share price over the course of the year, barring changes in implied volatility. In other words: we can figure out what our maximum profit is going to be, where the breakeven point lies and how wide the profit zone is.


Let me illustrate the concept of in-the-money covered call writing by showing the next graph. Three weeks ago, the $150 call July 2021 expiration on Crown Castle was set to yield the following returns (excluding dividends):

(Source: Option Generator's Research)


Thanks to immediate breakeven reduction, we're not playing the same game as the buy-and-hold investor. It's possible that holding shares in CCI results in a loss over the next 1 year, whereas the in-the-money covered call strategy remains profitable as long as the shares remain above $130 at expiration in July 2021. As a result, we should witness a weaker directional relationship, which is called correlation. In some cases, I believe in-the-money covered call writing can act like a bond-replacement strategy: lowered standard deviation (because of a smaller net long delta) while collecting a small daily coupon in the form of time value.


5% In-The-Money Covered Calls on American Tower From June 2010 to June 2019

5% in-the-money covered calls vs. buy-and-hold performance: returns

Let's first elevate the forward 1-year returns for 5% in-the-money covered calls with a 1-year duration on AMT. For example: we enter a covered-call trade on June 1, 2010 and take a look at the return on June 1, 2011 ... we finally execute our last monthly trade on June 1, 2019 and take a look at our June 1, 2020 return. We do the same with a buy-and-hold approach. Both strategies are not managed and don't factor in the dividend distributions.The in-the-money covered call is thus held until expiration, as the backtesting results should paint a fair picture.


Please keep in mind that the in-the-money covered call trades that would have been entered during the extremely high IV readings in March of this year are NOT included in the study. That's because the realized forward 1-year return is still unknown as it will depend on AMT's share price in March 2021.


As can be read in one of our previous articles, the relationship between realized in-the-money covered call returns and implied volatility is linear.

(Source: Option Generator's Research)


Below, you have the 1-year forward return for any given month up until June 2019. For example, the 1-year forward return for an ITM covered-call trade executed on August 1, 2011 would have been 13.2%.

(Source: Option Generator's Research)


Taking a closer look at where the bulk of the returns and outliers for ITM covered calls are situated, we notice that no observation yielded a negative P&L (lowest was 0.63%).

(Source: Option Generator's Research)


As for the stock returns, we do see a lot of variation in the data with a maximum loss settling at around 9%. In fact, 24% of the time AMT's forward 1-year buy-and-hold performance was below the average ITM covered call return.

(Source: Option Generator's Research)


5% in-the-money covered calls vs. buy-and-hold performance: beta and correlation

Regarding the beta of the ITM covered call strategy compared to buy-and-hold investing, the sensitivity to changes in AMT's share price is +0.0219.

(Source: Option Generator's Research)


When it comes to the average correlation between ITM CC and buy-and-hold performance for all circumstances, this number equals to +0.2 and has remained pretty static over the last years.

(Source: Option Generator's Research)


Conclusions for American Tower

ITM covered call writing on AMT has been a consistently profitable strategy over the past decade. Moreover, correlation with the buy-and-hold performance has remained fairly stable as well as the beta which approaches 0. In essence, by continuously selling in-the-covered calls on AMT, one would have executed a strategy that delivers a high probability of profit, small beta (because of being capped on the upside and receiving breakeven reduction in return) and moderately positive correlation (which we don't have when selling monthly covered calls).


By giving your long AMT position a completely different dimension, you can smooth the risk out and let the probabilities work out in your favor. The standard deviation in the ITM covered-call returns has been 1.8% over the past decade, while the average gain was 6.0%. In essence, the average return equals to 3.3 times the risk taken. The buy-and-hold investor would have generated a 19.4% return with 14.4% standard deviation in the observations. All these numbers exclude dividend distributions.


5% In-The-Money Covered Calls on Johnson & Johnson From June 2010 to June 2019

5% in-the-money covered calls vs. buy-and-hold performance: returns

Let's first elevate the forward 1-year returns for 5% in-the-money covered calls with a 1-year duration on JNJ. For example: we enter a covered-call trade on June 1, 2010 and take a look at the return on June 1, 2011 ... we finally execute our last monthly trade on June 1, 2019 and take a look at our June 1, 2020 return. We do the same with a buy-and-hold approach. Both strategies are not managed and don't factor in the dividend distributions. The in-the-money covered call is thus held until expiration, as the backtesting results should paint a fair picture.


Please keep in mind that the in-the-money covered call trades that would have been entered during the extremely high IV readings in March of this year are NOT included in the study. That's because the realized forward 1-year return is still unknown as it will depend on JNJ's share price in March 2021.


Looking at the ITM covered call and buy-and-hold performance, we'll notice that there are quite some red and yellow dots. Because of lower implied volatility than AMT, the initial option credits and thus final returns will be lower. Consequently, negative skew is expected to seriously affect the average outcome. As covered-call writing results in defined profits, positive skew is less likely, barring high IV levels at order-entry.

(Source: Option Generator's Research)


Below, you have the 1-year forward return for any given month since June 2010 up until June 2019. In contrast to AMT's return picture, selling in-the-money covered calls on JNJ hasn't been worth the effort. However, we shouldn't simply draw premature conclusions from a return graph. The portion of risk-taking to get those profits needs to be gauged as well.

(Source: Option Generator's Research)


Illustrated by the box plots for each year, we observe the negative outlier move in the 1-year forward returns for trades entered in 2014 (of which the outcome was dictated by JNJ's share price in 2015). The average return over the past decade would have been roughly 3% with the standard deviation approximating 1.43%.

(Source: Option Generator's Research)


The same picture arises for the buy-and-hold investor: a lot of variations when evaluating the forward 1-year returns. This highlights the difficulty of timing your stock purchases. Sometimes you'll end up owning a stock that appears to be dead money for the next 1 year or longer. That's not the amount of consistency defensive investors are looking for. Moreover, 32% of all buy-and-hold returns would have been beaten by a simple in-the-money covered call write.

(Source: Option Generator's Research)


5% in-the-money covered calls vs. buy-and-hold performance: beta and correlation

Regarding the beta of the ITM covered call strategy compared to buy-and-hold investing, the sensitivity to changes in JNJ's share price is +0.0308. Once the stock starts declining, a lineair pattern between ITM CC and buy-and-hold returns shows up.

(Source: Option Generator's Research)


Since we don't collect a very decent options credit on JNJ, a declining share price will cause the correlation between the buy-and-hold and in-the-money covered call performance to converge. Overall, the correlation is moderately positive (+0.20).

(Source: Option Generator's Research)


Conclusions for Johnson & Johnson

In terms of correlation, beta and standard deviation, the picture looks almost identical to that of AMT. However, one should not ignore the substantially lower implied volatility priced into JNJ's options. The average return is half that of AMT, while the standard deviation is 30% lower but with a greater percentile of losing trades. The average return is 2.2 times the risk taken.

Negative outlier moves tend to be more frequent as well. All in all, JNJ is not a good vehicle for in-the-money covered call writing because of its low IV. At Option Generator, we target an annualized return of 7%-10% for in-the-money covered calls to get enough bang for our buck and to reduce the cost-basis considerably. The question now becomes: what about a stock that has more implied volatility such as Salesforce.com?


5% In-The-Money Covered Calls on Salesforce.com From June 2010 to June 2019

5% in-the-money covered calls vs. buy-and-hold performance: returns

Let's first elevate the forward 1-year returns for 5% in-the-money covered calls with a 1-year duration on CRM. For example: we enter a covered-call trade on June 1, 2010 and take a look at the return on June 1, 2011 ... we finally execute our last monthly trade on June 1, 2019 and take a look at our June 1, 2020 return. We do the same with a buy-and-hold approach. Both strategies are not managed and don't factor in the dividend distributions. The in-the-money covered call is thus held until expiration, as the backtesting results should paint a fair picture.


Please keep in mind that the in-the-money covered call trades that would have been entered during the extremely high IV readings in March of this year are NOT included in the study. That's because the realized forward 1-year return is still unknown as it will depend on CRM's share price in March 2021.


As can be noticed from the graph below, the red dots are wide-spread, whereas the yellow ones are virtually perfectly correlated with the implied volatility level at order-entry. Given the noticeably higher standard deviation in Salesforce's buy-and-hold returns (of 20.6%), we'd expect to see more variations.

(Source: Option Generator's Research)


Except for the three negative outliers, continuously selling 5% in-the-money covered calls on CRM has led to fairly consistent returns.

(Source: Option Generator's Research)


Looking at the forward 1-year buy-and-hold returns for each month, there are a lot of outliers to both the upside (+75%) and downside (-28%).

(Source: Option Generator's Research)


The box plots give us a perfect overview of the data distribution. For all observations in ITM CC, the spread between the 25% and 75% percentile is narrow, i.e. 4.3%. The 25% best trades would have had an average 1-year return in excess of 13.5% with the maximum profit standing at 19.4% without any type of management. The minimum return would have been - 7.91%, while the average profit amounts to 11.0% with 3.9% standard deviation.

(Source: Option Generator's Research)


As for the buy-and-hold results, the spread between the 25% and 75% percentile stands at 27.53%, indicating the variance in the data. More importantly, 31.48% of the time, the in-the-money covered call write would have outperformed the buy-and-hold strategy. To get the average return of 22.3% we need to take the standard deviation of 20.6% into account.

(Source: Option Generator's Research)


5% in-the-money covered calls vs. buy-and-hold performance: beta and correlation

The beta of the options strategy compared to buy-and-hold investing is close to 0, a conclusion that we've already come up with in the data analysis for AMT and JNJ. To put another way, we'll experience less directionally pronounced outcomes for the defensive options strategy.

(Source: Option Generator's Research)


Talking correlation, there seemingly doesn't exist a relationship between forward 1-year returns for buy-and-hold investing and in-the-money covered calls. We, therefore, believe that in-the-money covered call writing on the right underlyings can be utilized as both a beta and correlation reductor.

(Source: Option Generator's Research)


Conclusions for Salesforce.com

Salesforce.com has proven to be an excellent in-the-money covered call vehicle as it not only exhibits relatively small standard deviation per unit of return (3.9% standard deviation on an average 11.0% return), but also acts as a zero-correlation strategy with buy-and-hold investing. If Salesforce.com were to go down, there's no guarantee of seeing a loss on an in-the-money covered call trade.


Overall conclusions

In-the-money covered call writing leads to lower standard deviation in your final returns compared to buying stock outright. However, we should target a minimum annualized return of at least 7% to make sure that we get a decent risk-adjusted return. As for JNJ, it's generally not worthwhile selling in-the-money covered calls as the data are negatively skewed due to outliers and low IV. Despite the fact that Salesforce has been a volatile underlying over the past decade, the chances of experiencing a double-digit loss on a forward 1-year basis could have been reduced significantly by choosing a 5% in-the-money covered call.


If done properly, this defensive options strategy can act as a bond-replacement vehicle. With the VIX at 28%, many minimum-volatility stocks such as AMT, ACN, PGR et cetera provide ample opportunities to sell in-the-money covered calls if one seeks an attractive risk-reward profile.

Option Generator AM

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