In a previous column in Investment Executive (February 2014), I warned about strategies offering lofty promises that are unlikely to be kept. Selling call options against long equities positions is one such strategy. I came across a recent article that picked apart the covered-call strategy to understand its sources of return and risk. If you use this strategy, you’ll find the article insightful.

In “Covered Call Strategies: One Fact and Eight Myths,” published in the November-December 2014 issue of Financial Analysts Journal, authors Roni Israelov and Lars N. Nielsen characterize covered calls as a form of low-beta investing because selling covered calls lowers the effective beta exposure to the underlying equities. Covered calls’ “downside protection” can be much more efficiently achieved by directly reducing equities exposure, they argue.

The authors further state that the “income” generated by selling call options is revenue but not income, and remind us that income is revenue minus costs.

To clarify, the authors draw an analogy to a strip or zero-coupon bond. The seller of the bond – i.e., the borrower – receives a lump sum up front in exchange for a future liability. The present value of the liability is equal to the upfront cash received by the seller – equating to zero profit or income.

Similarly, the authors argue, the options seller receives immediate cash flow in exchange for a future liability. The liability is the seller’s obligation to sell the stock at the strike price. But if the buyer of the call option chooses to exercise, the option seller will sell the stock at below-market prices. That is the cost of obtaining that upfront premium cash flow.

The call option strategy’s total return, then, is: the sum of the long equity position plus the cash flow received up front, minus the cost of the future liability upon option exercise. If the option is efficiently priced, the cash flow received by the option seller is equal to the present value of that future associated liability – like in the strip-bond analogy.

So, the real source of additional return from covered calls is present only when the option price implies a volatility level for the equity that is higher than the actual realized volatility.

To use another analogy, I’ve heard fund portfolio managers speak of commodity stocks as, for example, “being priced for $80 oil” or “implying a $900 gold price.”

The authors argue that selling calls shouldn’t be done indiscriminately for cash flow. Rather, selling calls adds value only when the volatility embedded in the option price – i.e., the implied volatility – is higher than actual volatility (which can be confirmed only in hindsight). And if you’re selling an option that “overprices” volatility, selling the option makes you short on volatility. Accordingly, the authors equate covered calls as being long equity and short volatility.

Simply generating cash flow isn’t sufficient motivation for selling options, the authors argue, as the liability associated with selling options will offset the upfront cash flow. The only true source of return comes from accurately pricing volatility and selling it when it’s overpriced.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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