Covered call strategies may be useful for generating profits in flat markets and, in some scenarios, they’ll provide higher returns with lower risk than their underlying investments. In this text, you may learn how you can apply leverage so as to further increase capital efficiency and potential profitability.
Three methods for implementing such a method are through using several types of securities:
While all of those methods have the identical objective, the mechanics are very different, and every is healthier suited to a specific sort of investor’s requirements than the others.
Covered Call Returns
Covered call strategies pair an extended position with a brief call option on the identical security. The mixture of the 2 positions can often lead to higher returns and lower volatility than the underlying index itself.
For instance, in a flat or falling market the receipt of the covered call premium can reduce the effect of a negative return and even make it positive. And when the market is rising, the returns of the covered call strategy will typically lag behind those of the underlying index but will still be positive. Nonetheless, covered call strategies are usually not at all times as secure as they seem. Not only is the investor still exposed to market risk but additionally the danger that over long periods the accrued premiums might not be sufficient to cover the losses. This example can occur when volatility stays low for an extended time period after which climbs suddenly.
Applying Leverage
Leveraged investing is the practice of investing with borrowed money so as to increase returns. The lower volatility of covered call strategy returns could make them a great basis for a leveraged investment strategy. For instance, if a covered call strategy is predicted to supply a 9% return, capital may be borrowed at 5% and the investor can maintain a leverage ratio of two times ($2 in assets for each $1 of equity); a 13% return would then be expected (2 × 9% – 1 × 5% = 13%). And if the annualized volatility of the underlying covered call strategy is 10%, then volatility of the two times leveraged investment could be twice that quantity.
In fact, applying leverage only adds value when the underlying investment returns are significantly higher than the price of the borrowed money. If the returns of a covered call strategy are just one% or 2% higher, then applying 2 times leverage will only contribute 1% or 2% to the return but would increase the danger sharply.
Covered Calls in Margin Accounts
Margin accounts allow investors to buy securities with borrowed money, and if an investor has each margin and options available in the identical account, a leveraged covered call strategy may be implemented by purchasing a stock or ETF on margin after which selling monthly covered calls. Nonetheless, there are some potential pitfalls. First, margin rates of interest can vary widely. One broker could also be willing to loan money at 5.5% while one other charges 9.5%. As shown above, higher rates of interest will cut profitability significantly.
Second, any investor who uses broker margin has to administer their risk rigorously, as there may be at all times the likelihood that a decline in value within the underlying security can trigger a margin call and a forced sale. Margin calls occur when equity falls to 30% to 35% of the worth of the account, which is such as a maximum leverage ratio of about 3.0 times. (Note: margin = 100/leverage).
While most brokerage accounts allow investors to buy securities on 50% margin, which equates to a leverage ratio of two.0 times, at that time it might only take a roughly 25% loss to trigger a margin call. To avoid this danger, most investors would go for lower leverage ratios; thus the sensible limit could also be just one.6 times or 1.5 times, as at that level an investor could withstand a 40% to 50% loss before getting a margin call.
Covered Calls With Index Futures
A futures contract provides the chance to buy a security for a set price in the long run, and that price incorporates a value of capital equal to the broker call rate minus the dividend yield.
Futures are securities which might be primarily designed for institutional investors but are increasingly becoming available to retail investors.
As a futures contract is a leveraged long investment with a positive cost of capital, it may possibly be used as the idea of a covered call strategy. The investor purchases an index future after which sells the equivalent variety of monthly call-option contracts on the identical index. The character of the transaction allows the broker to make use of the long futures contracts as security for the covered calls.
The mechanics of shopping for and holding a futures contract are very different, nonetheless, from those of holding stock in a retail brokerage account. As an alternative of maintaining equity in an account, a money account is held, serving as security for the index future, and gains and losses are settled every market day.
The profit is a better leverage ratio, often as high as 20 times for broad indexes, which creates tremendous capital efficiency. The burden is on the investor, nonetheless, to make sure that they maintain sufficient margin to carry their positions, especially in periods of high market risk.
Because futures contracts are designed for institutional investors, the dollar amounts related to them are high. For instance, if the S&P 500 index trades at 1,400 and a futures contract on the index corresponds to 250 times the worth of the index, then each contract is the equivalent of a $350,000 leveraged investment. For some indexes, including the S&P 500 and Nasdaq, mini contracts can be found at smaller sizes.
LEAPS Covered Calls
Another choice is to make use of a LEAPS call option as security for the covered call. A LEAPS option is an option with greater than nine months to its expiration date. The LEAPS call is purchased on the underlying security, and short calls are sold every month and acquired back immediately prior to their expiration dates. At this point, the following monthly sale is initiated and the method repeats itself until the expiration of the LEAPS position.
The price of the LEAPS option is, like several option, determined by:
- the intrinsic value
- the rate of interest
- the period of time to its expiration date
- the estimated long-term volatility of the safety
Despite the fact that LEAPS call options may be expensive, as a result of their high time value, the price is often lower than purchasing the underlying security on margin.
Since the goal of the investor is to attenuate time decay, the LEAPS call option is usually purchased deep in the cash, and this requires some money margin to be maintained so as to hold the position. For instance, if the S&P 500 ETF is trading at $130, a two-year LEAPS call option with a strike price of $100 could be purchased and a $30 money margin held, after which a one-month call sold with a strike price of $130, i.e., at the cash.
By selling the LEAPS call option at its expiration date, the investor can expect to capture the appreciation of the underlying security throughout the holding period (two years, within the above example), less any interest expenses or hedging costs. Still, any investor holding a LEAPS option must be aware that its value could fluctuate significantly from this estimate as a result of changes in volatility.
Also, if throughout the next month the index suddenly gains $15, the short call option may have to be bought back before its expiration date in order that one other may be written. As well as, the money margin requirements will even increase by $15. The unpredictable timing of money flows could make implementing a covered call strategy with LEAPS complex, especially in volatile markets.
The Bottom Line
Leveraged covered call strategies may be used to tug profits from an investment if two conditions are met:
- The extent of implied volatility priced into the decision options have to be sufficient to account for potential losses.
- The returns of the underlying covered call strategy have to be higher than the price of borrowed capital.
A retail investor can implement a leveraged covered call strategy in a regular broker margin account, assuming the margin rate of interest is low enough to generate profits and a low leverage ratio is maintained to avoid margin calls. For institutional investors, futures contracts are the popular alternative, as they supply higher leverage, low rates of interest and bigger contract sizes.
LEAPS call options may be also used as the idea for a covered call strategy and are widely available to retail and institutional investors. The problem in forecasting money inflows and outflows from premiums, call option repurchases and changing money margin requirements, nonetheless, makes it a comparatively complex strategy, requiring a high degree of study and risk management.