Download Income Solutions: The Case for Covered Calls

Income Solutions: The Case for Covered Calls
An advantageous strategy for a low-yield world
Covered call writing is a time-tested approach that can add income, dampen volatility and diversify both equity and fixed
income core strategies. Adding a covered call strategy in a core-satellite, multi-asset-class approach can be accomplished
as:
•
A hedged equity strategy with an “income kicker” to enhance overall income production
•
A supplement to a core large-cap strategy (especially late in the market cycle when valuations are long-in-the-tooth
and price action is volatile) as a means of boosting income and mitigating downside risk
•
A better-yielding alternative to a high yield bond allocation
We believe that investors are well-served by strongly considering the addition of an income-producing covered call
strategy in virtually all market environments and multi-asset class strategies. Madison’s active call writing/active stock
selection approach provides more opportunity for premium income and alpha from underlying security selection than
common passive call writing.
Total Return of the BXM and S&P 500 1987-2013
Source: Morningstar
Rolling Returns
Time Period: 1/1/1987 to 12/31/2013
Rolling Window: 1 Year 1 Year shift
40.0
35.0
30.0
25.0
20.0
15.0
Return
10.0
5.0
0.0
S&P 500
-5.0
-10.0
CBOE S&P 500 Buywrite BXM
-15.0
-20.0
-25.0
-30.0
-35.0
-40.0
1989
S&P 500 TR USD
1991
1993
1995
1997
1999
2001
2003
5
200
2007
2009
2011
2013
S&P 500
Buywrite
BXM volatility
Covered calls show equity-likeCBOE
returns
with
lower
Source: Morningstar Direct
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Covered Call Strategy(A)
Benefits of Individual Stock Options vs. Index Options
Stock Price
Call Option
% Out of the
Money
Option Price
Option Premium
Annualized
Performance
CBS Corp.
$51.99
Jun $54.59
5.0%
$1.93
3.71%
13.4%
Apple Inc
$101.86
Jun $106.95
5.0%
$3.42
3.36%
12.1%
Schlumberger Ltd
$76.15
Jun $79.95
5.0%
$2.41
3.16%
11.4%
S&P 500 (SPDR)
$200.63
Jun $210.65
5.0%
$1.68
0.84%
3.0%
Security
Individual Stocks Options(B)
Actively Managing Income and Growth
Stock Price
Call Option
% Out of the
Money
Option Price
Option Premium
Total Return
If Exer.
Apple Inc
$101.86
June $101.86
1.0%
$5.59
5.49%
6.5%
Apple Inc
$101.86
June $112.04
10.0%
$1.97
1.93%
11.9%
Security
Source: Madison (Sample Data Only). Securities are identified for illustrative purposes only and do not represent a recommendation to buy
or sell nor the actual prices for these securities at any particular time. At any given time there may be greater opportunities for option writing
on individual securities than on indices, however not every individual security produces potential option premiums in excess of index options.
A) Stock prices as of 3/7/16 close. Call option prices are theoretical based on being 5% out-of-the-money.
(B) Stock prices as of 3/7/16 close. Call option prices are theoretical based on noted % out-of-the-money.
What is a Covered Call Strategy?
A covered call strategy owns shares of a publicly traded company, while selling (or writing) call options on the same
assets. Call options give the buyer of the option the right to purchase the stock at a predetermined “strike price” within
a set time frame (typically nine months or less). Selling call options produces income to the portfolio, which can be
distributed or reinvested: known as a “buy/write” strategy, the income may act as a source of yield to the investor, or can
be reinvested to help offset losses in a market decline.
Several peer-reviewed studies suggest that a covered call strategy performs at least in-line with the S&P 500 Index over
longer periods of time, while realizing lower standard deviation of returns.(1) The return profile is appealing, but investors
must be aware that the performance of covered call strategies differs with market environments.
The covered call strategy tends to underperform in steadily- or sharply-rising markets as the income generated by
covered call writing is offset by the opportunity cost of having appreciating, underlying assets called away. Income
generated by selling covered calls in this environment tends to constitute the bulk of returns (supplemented by limited
capital gains on the underlying stocks).
(1) An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns, Asset Consulting Group, January, 2012
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Downside Protection
In sideways and down market environments, covered call writing tends to outperform due to the significant income
generated from selling calls, as well as dividend income from the underlying stocks and any alpha generated by the
security selections of an active manager. Of course, even with the downside protection provided by the call premium
and dividends, there is a greater likelihood that the options will expire worthless (out of the money) in this environment,
leaving the portfolio holding the stock along with the premium income. While a steep market decline, such as that
experienced in 2008, can result in a negative total return in a covered portfolio, its performance should exceed that
of its underlying assets by roughly the amount of the premiums (minus expenses). We would argue that the current
environment of full valuations and market volatility is favorable for covered call writing strategies.
The Income Advantage
A primary attraction of writing covered calls is immediate income; the premium can vary depending on the security
involved, the price history of the stock and the market environment. A volatile stock will likely offer higher call premiums,
and the overall premiums for calls will rise as overall market volatility rises. This pattern is popularly measured by the
Chicago Board Options Exchange Market Volatility Index (“VIX”), which tracks the implied volatility of S&P 500 index
options. The premium income from writing these calls can provide an alternate method for generating yield.
A report published in January 2012 gives a sense of the income potential of covered call writing, showing 1.8% historic
monthly yield of the BXM between June 30, 1986 and December 31, 2011.(2) Option income is usually taxed as shortterm gains, making the strategy best suited for tax-deferred and tax-exempt assets, but, depending on the length of the
option, income may also be taxed as long-term gain.
Potential for Positive Return in a Flat Market
A covered call strategy can be a powerful alternative strategy for performance in a flat market. Writing calls with a strike
price out-of-the-money (e.g. $55 on a $50 stock) allows room for capital appreciation, while earning the call premium. Outof-the-money calls have a strike price higher than the current market price of the underlying security. Across a diversified
portfolio of stocks on which call options are written, the premium income can boost returns above a stock-only portfolio
in a year in which the traditional stock indices are up nominally. In the past, there have been long periods of flat returns
in the equity market: these are the periods in which a covered call allocation can be a significant driver of value-added
returns. The least conducive environment for a covered call strategy is a steeply advancing market, since much of the gain
on underlying securities will be truncated by the securities getting called away at strike prices lower than the advancing
market price.
An Analytical Review of a Covered Call Strategy
A study by Goldman Sachs in January 2012(2) reviewed 16 years of covered call trades (1996-2011) and concluded,
“overwriting added to returns and lowered the risk of diversified portfolios.” The extent of the advantage was quantified
as 3.6% annually, with a reduction of standard deviation of monthly returns by 20%. These results were predicated on
selling 10% out-of-the-money, one-month covered calls on S&P 500 stocks with liquid options. In addition, the study found
better results from writing calls on large-cap over small-cap companies, while there was no significant difference between
value and growth stocks. The results were also based on writing covered calls on a large number of stocks, with a specific
(10%) out-of-the-money prescription, using one-month options. While this methodology differs from Madison’s covered
call writing strategy, it lends credence to our belief that a carefully managed covered call strategy has the potential to
produce attractive returns, reduce risk and provide meaningful additional income.
(2) Overwriting Observations: a 16-year Study, Goldman Sachs, January 19, 2012
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Madison’s Covered Call Management
Active Stock Selection – Madison starts with a growth-at-a-reasonable-price (GARP) approach to build the underlying
covered call equity portfolio. The process seeks to select high-quality companies, which have solid balance sheets,
excellent profitability, strong management and elicit confidence in continued profitability. We seek to purchase such
companies when their valuations are reasonable, and when we see the available option premiums for the stock as
attractive. We focus on larger companies (market caps of $3 billion or more) that have a history of excellent return on
capital, strong long-term growth rates and positive cash generation. Historically, the majority of our investments have
been focused on the Financial, Technology, Consumer, Health Care, Energy and Industrial sectors.
Our active stock selection process, which includes rigorous fundamental analysis of all portfolio candidates, results in
a high-conviction portfolio of 40-70 stocks. We seek to avoid over-priced and speculative issues through our valuation
discipline. We expect the stock component of our portfolio to show lower volatility and better downside protection than
the market in general.
Active Call Writing – We purchase individual stock options, rather than index options, because we believe individual stock
options can offer higher premiums. Typically we write out-of-the-money calls which allow for the potential for upside
participation if the underlying stock price advances. When selecting options, we look at the outlook for the underlying
stock, the outlook for the overall market, the implied volatility history of the stock and the absolute and annualized
total return potential for each stock/option combination. We often have multiple calls written for the same stock in the
portfolio, giving us a range of strike prices and option expiration dates.
Why Madison Covered Call?
Madison has been a leader in covered call management since 2004: the Madison Covered Call and Strategic Equity Fund
(MCN) was the first closed-end covered call strategy fund traded on the New York Stock Exchange. The firm also manages
the Madison Strategic Sector Premium Fund (MSP), another closed-end fund traded on the New York Stock Exchange,
and the Madison Covered Call and Equity Income Fund, a proprietary, open-end mutual fund. Madison’s strategy of active
stock and option management differentiates its portfolios from the more common passive strategies, and provides an
opportunity to manage risk while exploiting the higher premiums available for individual stocks. The lead portfolio manager,
Ray DiBernardo, CFA, has been working on the strategy since its inception in 2004, and the team together brings nearly 60 years
of investment experience to their covered call clients.
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Disclosures
The writer of a covered call option forgoes, during the option’s
life, the opportunity to profit from increases in the market value
of the security covering the call option above the sum of the
premium and the strike price of the call, but has retained the risk
of loss should the price of the underlying security decline.
An investment in the fund or strategy is subject to risk and
there can be no assurance the fund or strategy will achieve its
investment objective. The risks associated with an investment
in the fund or strategy can increase during times of significant
market volatility. The principal risks of investing in the fund or
strategy include: equity risk, mid-cap company risk, option risk,
tax risk, concentration risk and foreign security and emerging
market risk. With regard to the fund, more detailed information
about these risks can be found in the fund’s prospectus.
For more complete information about Madison Funds®, including
charges and expenses, obtain a prospectus form your financial
advisor by calling 800.877.6089 or by visiting madisonfunds.com
and clicking on prospectus and reports to view or download a
copy. Before investing in the funds, considered the investment
objectives, risks, charges and expenses. The prospectus contains
this and other information about the fund and should be read
carefully before investing.
CBOE Volatility Index (VIX) is a key measure of market
expectations of near-term volatility conveyed by S&P 500® stock
index option prices. Since its introduction in 1993, VIX has been
considered by many to be the world’s premier barometer of
investor sentiment and market volatility.
CBOE S&P 500 BuyWrite Index (BXM) is the passive
representation of a covered call strategy. The BXM Index is an
unmanaged (passive) total return index based on buying the S&P
500® stock index portfolio and “writing” (or selling) the near
term S&P 500® Index “covered” call option (SPX) every month
with an exercise price just above the prevailing index level (i.e.,
slightly out of the money). The SPX call is held until expiration
and cash settled, at which time a new one-month, near-themoney call is written.
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S&P 500® Index (SPX) is a group of 500 widely held stocks
and is commonly regarded to be representative of the large
capitalization stock universe.
The VIX, BXM and SPX are unmanaged indices which do not
allow for direct investment. Indices are used in this piece for
illustrative purposes only and do not reflect the performance of
any particular Madison portfolio, fund or composite.
Volatility refers to the amount of uncertainty or risk about the size
of changes in a security’s or index’s value.
©2016 Morningstar, Inc. All Rights Reserved. The information
contained herein: (1) is proprietary to Morningstar and/or its
content providers; (2) may not be copied or distributed; and
(3) is not warranted to be accurate, complete or timely. Neither
Morningstar nor its content providers are responsible for any
damage or losses arising from any use of this information.
Although information in this report has been obtained from
sources that the firm believes to be reliable, we do not guarantee
its accuracy, and any such information may be incomplete or
condensed. All opinions included in this report constitute the
firm’s judgment as of the date of this report and are subject to
change without notice. This report is for informational purposes
only and is not intended as an offer or solicitation with respect to
the purchase or sale of any security.
1 Callan and Associates (October, 2006). “An Historical
Evaluation of the CBOE S&P 500 Buy Write Index Strategy.”
Ibbotson Associates (2004). “Highlights from a Case Study on
BXM Buy-Write Options Strategy.”
Hill, Joanne M.; Balasubramanian, Venkatesh; Gregory, Krag
and Tierens, Ingrid (2006). “Finding Alpha via Covered Index
Writing”. Financial Analysts Journal, vol. 62 no. 5. (September/
October 2006) pp. 29-46.
Madison Funds are distributed by MFD Distributor, LLC.
© Madison Investment Advisors, LLC and Madison Asset
Management, LLC. March 1, 2016. March 3, 2016.
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