Re-Thinking Asset Allocation
A Twist To The Traditional Covered Call Strategy
For the past six months I’ve been giving a lot of thought to how to structure portfolios that can protect downside risk in a market that is relatively expensive for both stocks and bonds. Fixed income (bonds) has traditionally provided diversification, income, and stability for the overall investment portfolio. However, now the fixed income market is offering depressed yields and potentially bubble prices to investors who are facing expectations of rising inflation that hasn’t been seen for over four decades. For the next few years or possibly decades, investors who need income to fund retirement goals may find it difficult to obtain the yields needed without shifting their portfolio to riskier parts of the bond market or even equities. Growth oriented investors with longer time horizons are also finding it difficult to balance between the growth and volatility of the market without the stability that a non-correlated hedge like fixed income has historically provided. At SEDNA Wealth Management, we’ve been re-thinking the traditional asset allocation model and looking to implore covered call strategies as a replacement for bonds to offer a diversified potential source of income while mitigating downside risks within the equity markets.
What Is Covered Call Writing?
A traditional covered call strategy is one of the most straightforward and widely used options-based strategies for investors who want to pursue income to enhance stock market returns. When writing (selling) a covered call, you’re selling someone else the right to purchase a stock or etf that you already own, at a specific price, within a specific timeframe. As a result of selling the call, you’ll collect the premium from selling a call option and because you own the stock you’re covered if the stock price rises past the strike price and the call options are assigned. You simply deliver the stock you already own and reap the benefit of a higher stock price and the premium for selling the option.
SEDNA’s Twist On The Traditional Covered Call Strategy
SEDNA’s use of covered calls differs to what most would consider the traditional covered call approach because we implore our proprietary Compass Risk Model to identify and select optimal strike prices for writing options on selected securities. The SEDNA Compass Risk Report, is a proprietary model that evaluates asset classes and stocks using a yearly (rolling 12 month) period to produce a short term (weekly) price range and directional trend for a given security. By identifying the price range and current trend of each security, we can selectively write covered calls at strike prices that are either bullishly or bearishly positioned towards the higher or lower end of the weekly price range. A traditional covered call strategy usually writes out of the money calls to gain income and some price appreciation. This works well when stocks are gradually moving up or sideways, but does a poor job of protecting the downside risk of the equity market. The SEDNA Covered Call approach seeks to use our proprietary model to write out of the money call options during short term bullish trends, but also write in the money options during bearish trends to offer greater downside price protection.
With the advent of weekly call options, there are now good opportunities sell the covered call options that can profit from both the option premium and short-term direction of a security within a given price range. A common scenario, especially when a security is trending upwards is to write an out of the money option at the top end of the range one week and then when the security reaches the top end of the range, roll the option into an in the money call the next week at a strike price that is closer to the bottom of the price range. This gives the investor the opportunity to use to profit from both the premium and short-term price movements as the security moves from week to week between a given price range. We also prefer to use large volume etfs (SPY, QQQ, IWM) or high market share stocks (AAPL, MSFT, etc.) that offer higher option volumes and trade with weekly expirations to take advantage of the substantial amount of premium certain options provide. Because our strategy differs from traditional covered call writing in that we believe prices for securities don’t go up and down in straight lines but rather fluctuate in wave like patterns, we have titled our approach the SEDNA Covered Call Wave Strategy (SCCWS).
Recently, a few changes in the structure of option trading have increased the opportunity to use SEDNA’s Covered Call Wave Strategy.
- Lower Commissions: Recently several brokerage firms went to a model of offering commission-free trading on most stocks and etfs, there usually is a per contract fee when it comes to options trades, but the fee reduction in general is great cost savings when rolling weekly options.
- Weekly Options: Weekly options are ideal for our covered call strategy and allow a greater chance of profiting during any market environment. By using the SEDNA Compass Risk Report as a pricing guide, we can continuously write calls at our optimal strike prices and roll into the following week, capturing substantial premiums while positioning for both bullish and bearish trends.
- Higher Option Volumes and Premiums: In July of 2020 Goldman Sachs reported that single stock option trading volumes were bigger than the underlying share volumes for the first time ever. The popularity of options both from retail and large institutions has driven volumes and option premiums to record levels. By selling (writing) call options on a weekly basis you are capturing income that can help the return stream of your portfolio.
Covered Call Strategies Can Generate Substantial Income Amid Periods of High Volatility
Equity markets are ripe with volatility these days. In periods of stress, volatility rises as stocks sell off and investors move towards lower-risk investments. Yet covered call strategies can turn volatility into an asset due the fact that option premiums are positively correlated to volatility. As volatility rises, option premiums increase and can create greater amounts of income for those selling covered call strategies.
Delivering Defensive Positioning With Covered Calls
The current investment landscape creates several concerns for both income and growth investors: heightened market turbulence, low bond yields, and a lack of non-correlated assets create challenges for diversified portfolios. Covered call strategies can play a useful role in a portfolio not just as a yield-generator, but also to potentially outperform in downturns and certain sideways markets.
Positioning As A Core For Your Standard Asset Allocation Portfolio
Strategies like SEDNA’s Covered Call Wave Strategy can play a variety of roles in a portfolio. It can be used to dampen downside risks due to premiums benefiting from volatility. Or it can provide a differentiated source of income and returns that typically behave differently from traditional stocks and bonds. Because of the defensive structure of covered call writing, we think it’s appropriate to take a 30/20 stock to bond replacement strategy when implementing this strategy within a portfolio. For the standard 60/40 portfolio that would mean placing up to 50% into covered calls by taking 30% from stocks and 20% from bonds, creating a 50/30/20 portfolio (Covered Calls/Diversified Stocks/Bonds). In the current environment, where income is scarce, and portfolios often suffer from over-concentration in correlated assets, we believe a strategy like SCCWS can serve as a core position for both growth and income-oriented portfolios.