#5: What Didn't Work in 2012

by Jay Pestrichelli on January 11th, 2013

As we wrote yesterday, we’re starting a 2 week series about the top 5 investment strategies that worked and didn’t work in 2012. Today we’ll begin with the #5 strategy that didn’t work: Covered Calls.
To say covered calls didn’t work is a little bit of a stretch, because there were ways to make them pay, but it was one of the hardest years to do it well and the rewards were often not worth the effort. As a reminder, a covered call is when a call option is sold against long stock as a means of generating premium. In return for that premium, you accept the obligation of delivering your stock at the strike price of the call, regardless of the market price.
Selling calls generates the most premium in volatile times. Call prices are higher and sellers have more choices of the strikes they choose. However, 2012 was a year of low volatility. As measured by the VIX, it actually had the lowest average since 2007 with an average spot price of 17.8. Even looking at the daily highs on the VIX for the year, it never closed above the 27 mark. Again, this has not been the case since 2007.
The low volatility caused sellers to tighten up their strikes and sell closer to the current price. That proved to be a challenge as well as the likelihood of assignment was higher in 2012 than in previous years. As a review, the risks associate with covered calls is the same as with owning stock. When the market drops you have downside risk of the long shares. Some of that decline is offset by the premium generated by the covered call. However, many new investors see the risks of covered calls as getting assigned. This is not true as most covered calls are sold at prices above the market price at the time. Therefore, getting assigned means the stock was sold at a higher price and you keep the premium. Not really a risk. Where the risk comes in, is what to do once assigned.  If you want to buy back the stock, you’re doing it at a higher price, so you need to be sure you want to buy high.
We bring this up because in all likelihood, call sellers were faced with this dilemma multiple times in 2012. Despite the low volatility of the year, there were many times stocks rose very quickly causing the calls to go in the money. The SPY, for example, had 6 monthly changes of greater than 3% from option period to option period compared to 4 the previous year. So there  was an environment of lower call premium witha higher likelihood of assignment; not the kind of combination we were looking for. 
At Buy and Hedge, we talk a lot about using calls to help offset the price of long put protection. These are called collars and historically, we’ve been able to buy protection and pay for it with call selling. The ratio we aimed for was selling calls 6% higher than the market and buying longer dated puts 10% below the market. Over time the calls are supposed to pay for the long puts. In 2012, it turned out to be very challenging to generate enough premium at the 6% level to offset the put costs. In fact that ratio was only able to be established 2 times in 2012 compared to the average 8 or 9 times we’ve seen in the past.; so even as part of a hedging strategy covered calls proved to let us down.
Finally, let’s check some Covered Call ETF as benchmarks to show it wasn’t just the individual that had challenges; it was institutional money managers as well. BWV (Barclay’s S&P500 Buy-Write ETF) and PBP (PowerShares S&P500 Buy-Write ETF) both had their worst year since 2008.  BWV was up 5.4% and PBP was up 4.2% compared to the SPY that was up 14.5%. All of these are on a dividend adjusted basis. In flat and down years, Buy-Write ETFs should outperform their indexes and these did in 2011 and 2008. In up years Buy-Write ETF’s should underperform, however 2012 was their biggest under-performance of the last 5 years only delivering 1/3rd of the returns of the index.
We believe selling calls should continue to be a part of a healthy hedging strategy, but in environments like 2012, you may need to adjust. That may mean go out an extra month or be willing to part with stock more often than in the past.  At Buy and Hedge, we’ve adjusted by selling out 3 months vs. just 1 and we’re finding that those premiums are making sense at levels we’re comfortable selling our positions.

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