Covered Calls: The Income Illusion
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- Опубликовано: 19 июн 2023
- Some investors are attracted to covered call funds because of their high income yields and seemingly high risk-adjusted returns. However, the appearance of high income and high risk-adjusted returns is the result of clever financial product design, not of actual improvements to returns or risk-adjusted returns.
Episode 171 with Campbell R. Harvey: • RR #171 - Campbell R. ...
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Sources:
Shefrin, H., & Statman, M. (1993). Behavioral Aspects of the Design and Marketing of Financial Products. Financial Management, 22(2), 123. doi.org/10.2307/3665864
Black, F. (1975). Fact and Fantasy in the Use of Options. Financial Analysts Journal, 31(4), 36-41. doi.org/10.2469/faj.v31.n4.36
Merton, R.C., Scholes, M.S., & Gladstein, M.L. (1982). The Returns and Risks of Alternative Put-Option Portfolio Investment Strategies. The Journal of Business, 55, 1-55. doi.org/10.1086/296153
Rendleman, R. J. . (1999). Option Investing from a Risk-Return Perspective. The Journal of Portfolio Management, 25(5), 109-121. doi.org/10.3905/jpm.1999.319700
Sharpe, W. F. (1994). The Sharpe Ratio. The Journal of Portfolio Management, 21(1), 49-58. doi.org/10.3905/jpm.1994.409501
Harvey, C. R., & Siddique, A. (2000). Conditional skewness in asset pricing tests. The Journal of Finance, 55(3), 1263-1295. doi.org/10.1111/0022-1082.00247
Van der Meer, Robert and Sortino, Frank and Plantinga, Auke, The Impact of Downside Risk on Risk-Adjusted Performance of Mutual Funds in the Euronext Markets (July 19, 2001). Available at SSRN: ssrn.com/abstract=277352
Leggio, K. B., & Lien, D. (2004). Is covered call investing wise? Evaluating the strategy using risk-adjusted performance measures. In C.-F. Lee, Advances in Quantitative Analysis of Finance & Accounting (Vol. 1, pp. 187-204). WORLD SCIENTIFIC. doi.org/10.1142/9789812565457...
Farago, A., & Hjalmarsson, E. (2023). Long-horizon stock returns are positively skewed. Review of Finance, 27(2), 495-538. doi.org/10.1093/rof/rfac021
Bessembinder, H. (2018). Do stocks outperform Treasury bills? Journal of Financial Economics, 129(3), 440-457. doi.org/10.1016/j.jfineco.201...
Goetzmann, W., Ingersoll, J., Spiegel, M., & Welch, I. (2007). Portfolio Performance Manipulation and Manipulation-proof Performance Measures. Review of Financial Studies, 20(5), 1503-1546. doi.org/10.1093/rfs/hhm025
Brooks, R., Chance, D., & Hemler, M. (2019). The “superior performance” of covered calls on the s&p 500: Rethinking an anomaly. The Journal of Derivatives, 27(2), 50-61. doi.org/10.3905/jod.2019.1.087
Shefrin, H., & Statman, M. (1993). Behavioral Aspects of the Design and Marketing of Financial Products. Financial Management, 22(2), 123. doi.org/10.2307/3665864
Calluzzo, P., Moneta, F., & Topaloglu, S. (2021). Complex instruments have increased risk and reduced performance at mutual funds. Critical Finance Review. doi.org/10.2139/ssrn.2938146
Portfolio Growth chart. Source: portfoliovisualizer.com
Every time I think I found a good investment product Ben ruins my plans, I'll thank you in 20 years
I'm glad the plain bagel gave you a shout-out... I'm enjoying the content so far!
Excellent video once again Ben. Keep up the good work!
I swear that this video and the "relevance of dividend irrelevance" video should be forced and required watching for anyone purporting themselves to be "finance experts". Great job!
Spoiler alert: Dividends are incredibly relevant to an income-based investor
@@itsalltakenup income-based investors are not investors who require income. They are biased or error-prone investors who need help figuring out how to spend from a portfolio. It's an important difference. Investors who require income should still be focusing on total returns.
It is always easy to talk in terms of rationality and logic. It is however, in terms of investing and money in general, a short sighted view of the "most efficient" way to invest if there is no consideration on psychological factors.
It is easy to tell people to eat healthy. It is hard to craft a plan and stimulate them to do it right, you will find most of the time telling them to just eat healthy and exercise is not actually of any help and will achieve nothing.
I understand this is not David Ramsey show lol. But just saying, maybe we should not tell people they are 'wrong' for certain decisions which fit their idea of handling money their own not super efficient way if there are other factors to consider around thr financial markets, and not personal factors necessarily.
@@roknrolla01 100%. There’s a difference between “this is an optimal strategy” vs “this is the only strategy”
@@roknrolla01 Not really the point for actual experts and advisors to literally lie just so you can feel cozy with the mental gymnastics you need to apply in order to feel correct.
"Income based" investors or whatever you call it follow sub-optimal strategies and in doing so accidentally trick/mislead their followers into thinking they are getting "free cash flow". If one truly and really cared about fixed income, other approaches would need to be taken into cosideration... and it would not be to build a portfolio of SCHD's galore.
Was waiting for this one!
We needed that rational reminder!
Both covered calls and writing puts are often sold as safe strategies but this video really openend my eyes to the incompleteness of the sharp ratio. I highly recommend reading Nassim Taleb as he really focuses on the idea of tail risk.
Every one of your videos has great citations, but this one is phenomenal! What a gold mine of information. The insights about the skewness of equity outcomes vs. covered calls (or any structure that caps the upside of equities long term), and how the Sharpe Ratio is abused without accounting for lost skewness, were fantastic! Your podcast guests were amazing, even if what they ultimately were doing is explaining to the CC crowd that Santa Claus doesn't exist.
Thanks!
Excellent vid Ben. I already listened to the podcast but wanted to see the vid too.
I think everybody who like covered calls ETF understand that they give up upside in exchange for getting dividends now, every month. Instead of waiting years when (ever?) portfolio grows enough to be able to take profit.
Love it! Thank you Ben
This is a good video. One item I may add is that the sales pitch of the buyers of call options being speculators and by writing covered call option, you are the "house" for that speculative activity by taking the opposite position. The problem with this logic is that the prices the option based on supply and demand and if everyone can become the "house" you eventually over supply the market to the point that you're better off being the buyer. The market's collective wisdom is what sets a fair price. Aside, the real house is the market itself which comes in the form of bid-asked spread and commission. Whether you buy or sell a call or a put option, you are _never_ truly the house. The retail investor always pay more than the market value and you always sell below market value at any given point in time. This is true even if you place a limit order as your order will not execute until it is no longer at market value. This is true even with individual stocks but with options, the short term nature makes the negative effects more pronounced when you repeat the process for many years.
The income/capital gain mental separation is too powerful. I know full well they shouldn’t have any affect but sometimes I turn off the rational voice just to bath in the warmth of “certain predictable” income
I hear ya'! I used to get triggered by some of my closer-to-retirement-than-me buddies and their insistence on "cash flow" generated by their dividends, and then me banging my head against the wall trying to explain how total return is more important... but I honestly lay off them now. I get it. The brain needing to be cozy is indeed powerful. It's also why some people hold more cash than they (probably) should. Understanding that "pace of mind" is important.
Heck, my portfolio has a slight REIT lean - which is also completely idiosyncratic risk - in a tax advantaged account! (Does not lead to higher expected returns) But I do it because it's a small enough slice and it being there fools my brain into thinking I am a "real estate investor"... whatever the heck that means. :)
Excellent learned allot. Ben keep up the good work hope you make more videos more often.
4:36 - when I make this point about tax inefficiency, the rebuttal I often get is, "I only do covered calls in a tax advantaged retirement account." So after I wince, I refer them to the previously solved problem about active trading underperforming passive indexing over retirement time horizons.
Exactly...
I agree that CC ETF's have high MER's, however I write Covered Calls on my own stocks. It's a good income strategy, and if the stock gets called away, I'm also happy to take the gain.
Legend is back
Good stuff mate, as always.
Covered Call ETF's are starting to be spruiked within Australia - an article recently from our flagship financial newspaper I think gave a realistic assessment of their use. The head of an ETF provider in Australia gave this comment:
“The strategy can succeed as a tactical play in a range-bound market. However, long-term investors are better off investing in ETFs that don’t put a ceiling on potential capital growth.”
While you are certainly correct, I do use certain specific funds that do some limited covered call strategies that don't experience capital erosion, but I am biased and I KNOW that I'm biased and choose to roll with it and "pay the psychology premium". There's a cost associated with it, but considering that I don't experience much more expensive biases like FOMO and panic selling, the psychological tradeoff is acceptable to me. There is something to be said for a reasonable investing strategy that fits an investor's psychology. Also, the dividends pay out even during a market crash, when I specifically DON'T want to sell total market index for cash.
Love the channel by the way. You do a great job.
Yep. This. Funds that generate cash flow without capital erosions do wonders for psychology, especially during hard times when you do not want to sell!
In that podcast episode with Meir Statman that I showed a clip from, he also talked about the difference between an error and a want.
Someone investing in a cc strategy because they think it has superior risk-adjusted returns is making an error.
Someone who recognises that they are making a sacrifice in terms of expected returns and portfolio quality, but still wants to invest in an asset for other reasons (behavior improvement, expression of values, non-standard preferences etc.) is expressing a want.
@@BenFelixCSI Thanks for reply, and again, great work, love the channel.
My investment in Qyld has done better than my investment in BND total bond ETF and SCHP . I use it more as a bond in my IRA. Comparing Qyld to QQQ is like comparing apples and oranges.
What about implementing the strategy yourself, without the need to rely on an ETF? Do these learnings also apply to Selling Puts? What about Selling puts + Selling Calls (also known as the Wheel strategy)?
This will trigger some people! 😂
Great video, as always.
Ben, do you mind sharing some good books that you recommend or that are behind you on the podcast? I’d love to hear some recommendations from you.
Thanks!
Very well-researched and informative as always 👏
It’s like selling some of your stocks to buy bonds. You give up the upside potential of the stocks you’re selling to obtain the steady income from the bonds you’re buying, resulting in lower total returns.
Exactly
Or you can just sell the amount of stock shares equal to the income you're looking for, but be better ahead because the return on stocks are higher in the long run over bonds.
What? Have. you compared the yields on most CC vs Bonds - they is the major difference. You are giving up some of appreciation for high yielding. monthly CF (10% or greater)
@@erranzimmermann1207 The problem is with an investor's emotional ability to 'sell off' a portion of their pie - whereas with distrubitons its 'forced' monthly (mainly)....its consistent and doesn't really timing the market.
@@MStar10 and that links with what Ben mentioned - it's mental accounting, which leads to sub-optimal portfolio selection. If someone needs monthly cashflow by selling off shares, there shouldn't be any market timing anyway.
I'm invested heavily in CC ETF's, I'm Canadian. My thoughts are that I'm purchasing income. I'm retired and require cash flow. If I held only non-dividend paying stocks, I would potentially be forced to sell in a downturn. With manual DRIP I can choose to reinvest the dividends or withdraw for living expenses. In Canada we have RRSP and TFSA (like Roth IRA), between them both I generate a substantial amount of income, more than I need. And my situation is unique in that I'm single with no dependents so long term, not an issue for me if stock prices decline. The other point I think is that the bull market days are over for the next decade. There is so much debt out there, the system is imploding, so why not capture some income on the way down?. Just my thoughts, I'm no expert but this works for me. Good video
what about other options with less risk like reits and dividend etfs.
Can you tell me what income cc etfs do you buy in Canada? Asking for my aunt.
You are suffering, the mental accounting bias, that treats dividends, and returns separately when it should all be together as total returns
@steftrando Seems like a logical course of action based on their current situation, in a volatile market moving to fixed income seems far more intelligent if you're near or at retirement age
@@A_man_not_your_man equities, outperform, fixed income, and pretty much every 30 year.
Skewing toward income is also useful to avoid needing to sell assets when markets are down. Other approaches include large cash or bond allocations, which are in turn reducing the potential return of the entire portfolio.
Oh, and by the way, risk is not the same as volatility, and all computations which assume risk is volatility are ignoring real world risks for an idealized simplification. This is a cognitive flaw that affects sharpe ratio and many related computations.
Thank you, Ben, for the continued education. I appreciate these videos along with the podcast that you and Cameron provide. I have missed a few of the last podcasts, but I am one of three. What are your blind spots when it comes to your investment theory?
@Callme_pamyla That's what we need, fake FA bot spam.
If I knew what my blind spots were, they wouldn't be blind spots! I do my best to get information from diverse sources, including those that disagree with my prior beliefs.
Good video. I hear about covered call ETFs on Prof G's podcast. I think people are drawn to them because it sounds like a "free" way to generate income. But there's still no such thing as a free lunch. I like how Ben Felix's videos basically always end with the same takeaway: "you're probably best off with a low-cost index fund..."
In periods where the index are flat over time it seems the income is better. e.g. S&P500 last 18mo, 2007-2013, 2000-2006, 93-94, many other time periods.
The last example is terrifying, people reaching these levels and not getting that is really bad… Happy with my diversified simple passive ETFs…
Good info .
So for those that are retired, and depend on income from their portfolio , what do you recommend ?
( The problem with just owning index funds, is if the market is down 20-30% in a year, you still have to sell to live off the proceeds .
Putting you in a hole that is difficult to ever catch back up. )
I use a mix of both traditional dividend ETFs and covered call ETFs and do very well. They both invest in traditional dividend stocks.
Have you held the through a bull market to compare their performance when upside is being limited?
After reading the income factory I have to say its up to the style. If you want returns and growth then investing in cc etfs most likely not your route. But for those that want CASH flow being diverse in a few of these cover calls and reinvest divs provides growth through cash. Some people like to be more liquid 🤷🏾♂
Just read the Income Factory description and I would have to imagine they would fundamentally disagree with each other (having watched all of Ben's material).
CASH flow is a mental account. Total returns are what matter. Catering to mental accounting is fine to the extent that it helps people behave better, but it will almost always lead to suboptimal portfolios.
@@BenFelixCSI depending on how much you can contribute and how much time you have. Also you ignored the fact that makes a huge point, total return has no true value until you sell. Where as an income investor has cash flow and real liquid being built monthly . I personally never have to sell and that mental state of never having to sell and only worry about what the cash flow does means more then you like to give it. Every business is about cash and what it can create. Total return to a certain degree is waiting to agree or see what the market says. Each style plays a pro and con. All about what you want. someone invested in certain blue chip long term like Intel are not doing as well like someone in a cover called etf allowing you to grow with reinvesting 👍
@@AntBoogieWorld What Ben implied is that you will both have better expected "cash flow" and total returns if you use normal passive index funds and sell part of the shares for your "cash flow". Even after selling parts of the position, you're expected to have more money in the position than with a covered call ETF, with the same "cashflow". "Cashflow" is just a mental concept that has no impact on technical properties of an investment (bar negligible transaction costs) and how much money you can have available at any point in time. You can emulate any "automatic cashflow" via selling parts of a position and still be better off.
Sorry you are just wrong .. for one selling stock for income is the worse way to get income. Read the income factory your style is one way and it's an old school way of doing things. With CC etfs paying higher then ever it makes no sense buying index to sell for cash flow. New ways are coming learn to check other styles... that style is dated. @@simonp6339
What are your thoughts on using covered call during flat/uncertain markets. Usually in conversations I dont hear much interest in the income aspect, only the hedge aspect, (thetagang wallstreet bets types)
All markets are uncertain and no market is flat on expectations.
Hello cat Felix, it was a great idea to include these podcast shorts at the end. You should do this more.
Thanks! I wasn't sure if it was a good idea. I'm glad you liked it.
Been waiting for this one...
same!!
Not sure to understand everything but it would be interesting to compare the performance of the professor with the one of the non student. At some point the market will change of direction this doesn't mean that the investor has to stick rigidly to a strategy that stops performing. But maybe I didn't understand correctly.
Thank you. Well timed and needed objective view esp for any age in retirement. Don’t chase yield?
Do skewness or kurtosis explain factor outperformance? For small cap investing, for example, why not think the risk/return premium is explained by the longer or fatter tail on the downside (e.g., a liquidity crunch comes along and puts smaller firms out of business while larger firms can weather it)?
We love Ben!!!! I don’t understand the hype for covered call ETFs.. especially for young investors
I think risk aversion differs across generations
Greetings Ben! I've been your subscriber for many years now and appreciate the work you do. There's one topic that has been bothering me very much about Index investing which is that of the impact of arbitrageurs on the actual returns of the index investing. Since index construction and timing of rebalancing is public information, arbitraguers can predict the composition and weights of securities in the indexes before the index is actually rebalanced. This would in theory allow them to take positions just before a index is rebalanced, going long on entrants and short on exits, and before the fund managers of index funds and ETFs rebalance, thereby profiting from the price movements. Doesn't this reduce the expected returns of ETFs and Index funds? This I guess is more pronounced in market cap based index funds/ETFs but I can see the same problem can affect any factor based funds. Thank you in advance if you decide to take on this subject.
Yes. This is well-documented and it's one of the reasons that my firm does not use typical market cap weighted index funds. Great idea for a video!
Is it then possible for us to play the same game if we know when the rebalancing is made?
@@KrishnanV9 Yes but, it would take a lot of work without the use of a computer program.
That is a Video I instantly need to watch, this is too Important Not to do it directly
What about the wheel strategy when working with options? If your covered calls are exercised, you then sell a covered put
The downside with covered calls is you're getting the worst of everything: equity volatility, generally terrible pricing on the OTM calls (OTM is very typical and all but required to achieve tax benefits if you're in the US), plus short gamma on the call
If you have the capital, a conversion offers better pricing dynamics. You sell the call and also buy the corresponding put. It's a lot more negative delta, so probably investors might want only one of these instead of several short call contracts.
What do you get in return?
- if the asset shoots up, you still end up worse off... Just like adding covered calls
- if the asset falls, the long put replaces the missing gamma on the short call, so you continue gaining on the hedge where the CC stops contributing
- the bonus: if the stock falls, the put tends to lose extrinsic value much less than the short call, so you end up getting an improvement which is not obvious from the outset
The position likely earns the most by choosing an at-the-money strike (it doesn't take much above ATM before it gets expensive). A good time to enter is on ex-dividend or at least one month before the next ex.
It's amazing to hear that there are funds out there with that kind of aum being run by people who don't understand how risk works :o
Hi, love the content! Just wanted to ask, you said in various videos that you would not talk about dimensional fund advisors funds as these are not available to DIY investors but as a late, DFA have launched various US/international small cap/value/profit ETFs. Could you make a video to review DFA ETFs and comment on their suitability for DIY investors? Thanks so much!
As far as I can tell from the prospectus documents, the ETFs seem to be market cap weighted, which seems to be a substantial difference from the funds. They do still seem to be a good way to target certain categories though. While there are some other options, there isn't an excessive abundance of ETFs targeting small cap value for instance. I would need to double check, but I think they are more expensive than the comparable Vanguard fund though.
Ben, i know this is off subject a bit, but trying to get a response from you. For a small cap value tilt, you recommend avuv, avdv. If held at market weight, would you recommend the tilt include aves (emerging value)? Something like 60/30/10, or leave it out due to the risks?
Can’t give specific advice, but I do include EM with a size / value tilt in my portfolios.
Ben takes another swing at dividend investors…. 🥊 🔥
i got a question. if selling covered calls is expected to underpreform the underlying asset in the longrun due to the upside skewness of returns, maybe it makes more sense to buy those calls instead. What if i were to buy deep in the money calls on a globally diversified market cap weighted index portfolio. Well since its deep in the money the return of the option should mimic exactly the return of the underlying with some extra leverage. As the option starts to get closer to maturity we can just roll it over, sell it and buy another one farther out in the future, perpetually. We can choose super long term options like LEAPS, to minimize transaction costs. I call this the Perpetually rolling deep in the money leaps strategy, and i think might provide a cheaper access to leverage, and offer investors access to leverage that doesnt have to reset daily in registered accounts. Instead of paying a margin interest rate, i pay for the cost of the LEAP and I feel like that might be cheaper. would love to see an analysis on this
Wow, very interesting - I would love to see more details on this strategy. I think options strategies are dismissed without going into the the different sub strategies that can be used (ie. Wheel strategy)
Can you respond to the concept of life cycle investing, that is using leverage, when cost effective, to more evenly distribute risk over one’s life time and therefore improving risk adjusted returns for retirement and other long term investments via the “free lunch” of diversification (in this case time diversification).
New to your channel! Liked and subscribed! 😊
My belief is that the market will have low relative returns for the next decade which is why I think a cc etf will be decent monthly income hedge. Also, selling on a monthly basis runs the risk of completely missing out on the few days/weeks of high performance that typically account for a funds overall yearly return.
Thanks for "covering" this subject!
Nice call out!
Hi guys. I have never hear Ben talking about commodities. Do u think water is a good investment? It seems non volatile and steady increasing.
That prof was quoting out of the money Put options.. which is same as In the money Covered Call writing. That gets a fat premium but not on upside of the underlying.
What if you also hold the underlying assets?
We really really need those videos in french!
Great video and content as usual. Does it imply calls (and indeed put) options are sold at a "fair" price? I would hypothetise that buyers over pay for options because of irrational utility of big gains and hence the option seller can capture a premium over time. Any empirical evidence supporting this?
This is known as the volatility risk premium, where implied volatility in option prices is higher than realized volatility.
It is well documented, but I think it is captured by my comments on skewness in the video. Volatility may not capture the full risk picture for an option seller. They can get hit hard by large moves in prices.
FYI there are some strategies that work better in Australia with higher income returns for for tax reasons. Not sure if there are any in Canada/US.
Depends what you're investing in and where you live. In Canada the majority of our stocks are dividend stocks. Our returns will be subject to US withholding tax if we just buy US stocks. However some funds I've invested in actually do have high returns as well as paying dividends. Usually they don't do covered calls on the entire portfolio, but for instance if you look at qqqy (the one on the TSA not the US one) it has kept up with or even surpassed QQQ. Or compare Yamz to AMZN. Pretty close performance.
This is very niche, but I think in some cases covered call ETFs/other derivatives products CAN have better risk adjusted returns.
For example, I'll be working at an options market maker meaning that my income is heavily correlated to the volatility in the market. Allocating a percentage of my portfolio to short volatility products (i.e. SVOL) and covered call ETFs allows me to hedge risk and capture over-performance in flat low vol market conditions that would otherwise reduce my income.
Very good point.
This is not the same as selling covered calls, which I thought the title meant. This is in reference to a fund that generates alpha via covered calls. FNGU or TECL are pretty decent in lowering interest rate environments.
I have only one covered-call ETF (SPYI) in my portfolio representing about 10% of my holdings. I am curious to see for myself how it performs over time. There is nothing to disagree with in Ben’s video; however, as someone who is just now retiring, dividends and distributions are important to me. Sure, I would like there to be at least some decent growth of the underlying assets, but the dividend and distribution income is equally important to me. I really don’t want to have to sell off any of my holdings (especially in a down market).
SWAN is an ETF that uses an option strategy to try and get high sharpe but it didn't work out.
NTSX is an ETF that uses leverage. It beat its 60/40 benchmark like it's supposed to but didn't beat straight stocks/S&P 500, which as a result is all right. It also didn't beat S&P 500 in terms of sharpe. It should be mentioned that even the straight 60/40 didn't beat the S&P in terms of sharpe in the last couple years. Bonds have been terrible recently.
Explain why rolling forward and out is not an effective strategy to not lose upside potential and still capture premium. Thanks!
Good question! How rare is it for a stock to increase so much and so steadily that you will be unable to catch up rolling forward and out? If you're patient you could play that game for years and eventually catch up with the stock while in the mean time pocket the time-decay extrinsic value on the premiums and be better off than someone who simply held the stock. I would like to see an example on how that would play out negatively, and how likely that would be. Early assignment is no argument since you can counteract that by re-buying the stock and re-selling the same call option. Every time you do that you pocket an additional time-premium, so that is even a good thing. The only problem is if the stock pays a divident and you get assigned just prior to the ex-dividend date. In that case you may potentially be set back by the dividend amount (worst case scenario). Then again you can work around ex-dividend option periods by either selecting a higher extrinsic value than the dividend amount, or skip selling options for that month altogether.
Finally 🎉
Does it make sense to buy covered call ETFs at or near a market top? Even Ben said they work best when u r expecting a flat or negative market
Not in my opinion, cc funds drop as quick as anything else, they just dont gain it back when they go up
If you can correctly predict a market top, covered calls are probably not the best strategy to capitalize on that prediction.
sell and buy options should be equivalent. Otherwise one side should always get premium in expense of other. But if sell option is suboptimal strategy, can we say that buying option is suboptimal too? Is options in general are suboptimal in all ways?
It's a bit more complicated. There are asymmetries in the way options work. Options are all about convexity, after all, and the convex curve isn't always symmetric. Evaluating optimal vs. suboptimal depends on what the basis for comparison is. Options trading is necessarily active trading, and since active trading is known to be suboptimal compared to passive indexing, in that sense all options trading is suboptimal. But if the basis for comparison is within the bubble of buying options vs. selling options, arguments can be made either way about which is optimal. Ultimately, the optimal option trading strategy is the one that best exploits mispricing of volatility.
This may be a dumb question, but I’m going to ask it anyway. If selling covered calls tends to underperform just holding the underlying asset, does that mean that buying covered calls should tend to over perform (ignoring taxes and fees)?
wow that's an interesting question
I agree, definitely an interesting question!
Not a dumb question. Selling covered calls reduces your exposure to the underlying equity. Buying calls can give you leveraged exposure to the underlying. Leverage increases expected returns.
Oh well …here I was thinking I will buy SPYI as they have the taxation part taken care of with fancy accounting and ROC income…..but I am wiser now ….great video.
What about Sortino ratio, which only considers the downside standard deviation but not the upside standard deviation? I think that it would be more accurate for returns with negative skewness.
Not necessarily, as negative skew events while extremely impactful are also rare enough that they even Sortino will not necessarily pick them up. Standard deviation is in the second moment of a distribution, so anything using it including Sortino will not always pick up third moments like skew.
Frank Sortino recognized that the Sortino ratio did not deal with skewness. He later suggested the Upside Potential Ratio which does a better job.
Sortino is a co-author of one of the papers Ben cited when talking about abuse of the Sharpe Ratio. The abstract basically says Sharpe bad, UPR good.
Ever since Ben made that article and responded to a comment on Reddit I've been hoping that he'd make a video on it.
Link? Would love to see the article and reddit post if it's not under blackout!
www.reddit.com/r/PersonalFinanceCanada/comments/13pu0zf/i_made_a_mistake_on_investment_covered_call_etfs/jlbnqdd/?context=3
UMAX etf covered call, is there an alternative with the same 13 companies?
How about ETF with 50%(in average) covered call position like QQQX that also come with tax treatment? In long terms it seems better than SPY. Thanks for your time in advanced.
I am new to the financial markets and just started investing since January 2022. I have been following your content for a while and (being a engineer/scientist myself) I appreciate the references to academical research that you quote. However, this suggests that all your statements are cut in stone. Particularly the "market is perfectly priced" hypothesis appears to still be in debate in the scientific cumminity. There is also the behavioural side to markets that seems to have just as much (or maybe even more) merit and scientific support, as I found out by listening to several people from the academic finance world. It would be nice if you would point out that you are in one of the possible scientific camps instead of asserting that there is only one valid way of looking at this. Can you comment on this? Again, I really appreciate your videos as it provides a lot of valuable information to dive in to. Thank you!
I’m not sure what you mean. This video that you are commenting on includes a clip from an interview with one of the founders of behavioural finance, and references academic literature that assesses covered calls from a behavioural perspective.
I don’t really consider myself to sit in either camp.
@@BenFelixCSI OK, I am sorry for the confusion. I might have gotten that impression from one of your older videos. Glad you pointed out that you have not taken sides of either camp. Thanks again!
When I boil things down and look at the price of an ETF over time and the distribution to its investors over time I fail to see a flaw in the investment despite all the technical stuff. Am I missing something? take XYLD for example. In 2014 it was $46, its at a low now of about $39 and if its paid its distraction monthly investors have been paid handsomely have they not? I fail to see the risk compared to holding the underlying equities.
You can dismiss most exotic ETFs simply because the fees are north of 1-2%, twice that of an actively managed ETF.
"Picking the pennies in front of the steamroller" - this is what writing options usually is.
Ben, can you confirm if you're referring to things like the YLDs, the JEPs, or both?
Maybe QYLD?
Excluding divided, investing in stocks is a negative sum game because of tax and fees. Where your total return will came at the expense of someone else lossing money. (Unless you believe the market will continue to gain in value indefinitely) Remember it doesn't matter how much you gained as capital appreciation when you sell the stok someone else is going to buy it and he might loose his investment. If a stock goes from $1 to $1000 but then the company goes to bankruptcy and there is nothing for the shareholders and the company never paid any dividends then overall investors lost money in that company. It doesn't matter how much profit a company made in it's lifetime unless it distribute it's profit to the shareholders investing in that stock will be s negative sum game because of the tax and fees and you can add the IPO amount to that as well.
It’s not a negative sum game due to valuation. The market does not value companies based on their dividends but on their earning less their investment. An easy way to think about it is that the market values companies based on the dividends that they could pay without changing their capital structure. They do not need to distribute an actual dividend to be valuable. Further to that, a company can distribute a dividend by raising capital rather than from earnings, making dividends a noisy signal for what the market values.
excellent.
I"m far far away from retirement and I"m sure there will be new "income generating" sources by the time I am, but for someone who is currently, or is close to retirement today would covered call ETFs be a decent investment then? Assuming they don't really worry or care about loss of potential capital appreciation over a 20-30 year time horizon ?
what if you see the covered call ETFs as a proxy or pseudo fixed rent? you achieve a higher rate, in exchange of exposure to permanent capital loss.
If you take the risk on that not happening in the long term to the S&P (have to take SOME risk somewhere!) makes for a pretty good risk/return balance.
Did you not watch the video? Your returns will be lower than holding the market...
Maybe it's why I prefer to look at Sortino ratio
I’d really love to see a debate between you and @passiveincomeinvesting because I hear really great POVs from both of you.
I love these so much!!! I can’t believe how great the incomes are.
Buying the DOW in 1929 got you back to the same level a few generations later in 1956.
Stocks markets always go up is so dumb it hurts
I’m so glad you brought this up, because it’s so wrong!
The only way to get a 1956 breakeven is if you ignore dividends and look at nominal returns. With dividends and real returns the recovery was much, much sooner.
Thats a good point and that view option is not available on a 100 year DOW chart. At least from what i can find online. I read an interesting book last year :The great Depression: A diary by Benjamin Roth--what a nightmare-- the govt and banks were brutal to the average investor and saver back then. @@BenFelixCSI
That’s one of my all time favourite books. Incredible perspectives. My main takeaway from it is that people are collectively resilient when faced with extreme circumstances.
"I just want that steady stream of income to build up" - 18 year old with $1000 invested in a covered call etf while the SP500 chugs up 20%
Thanks. I've thought about this and dividends a lot and struggled to make sense of the upside.
As someone quite practiced in TA and trading... I'd use a covered call strategy only as a form of "going short" against an asset I am long... that I prefer not to sell
I keep tiptoeing around selling options, even though I'm mostly passive ETF investor.
My idea is that for the couple of stock picks I want to try my luck with, why not selling out of money put options instead of buying them right away. But good points.
Experimentation can be the best teacher! That sounds like doing half of "the wheel" strategy
@@OurNewestMember Yeah, might as well do the other half when I get assigned. But as mentioned in the video, limiting myself from any big market jumps. But selling puts, I'm limiting myself from big discounts. Still to do just the puts feel better if I know I want to own the stock anyway.
Another way to think about adding derivatives to a retail equity portfolio is to add just enough where it encourages you to stick with the level of risk you believe you "should" take -- if that means selling calls so you feel comfortable holding equities, or selling puts so you stay invested, etc.
Another alternative is to reduce equity exposure and add a combo spread (where the short put premium pays for the long call exposure), so you still have some asymmetry
Point is, maybe it's less about "the right technique" rather than using the tools to help manage investor shortfalls -- I guess that was the "psychology" message already in the video...
Great video, thank you, thank you, thank you.
❤
Fidelity is promoting this thinking with "Income Strategies powered by OptionsPlay" which comes with a charge of $35/m.
Covered calls are great for income
I think this explanation misses a case when an investor wants to sell and has a certain portfolio shift due to stock grants they receive as a part of their compensation. This way it is risky to keep all the stocks (eggs in a single basket), so the strike price of an option would be a comfortable selling price either way.
I suppose it depends on what such an investor prioritizes. If they don't care *when* their shares are sold, and to a certain extent, for how much, sure, a CC is an alternative to an ordinary limit order to sell. But there is always the risk that the capped gain of the shares on exercise plus the premium credit from the call is less than the gain without the CC.
Great stuff
Not considering this myself , but still curious what everyone here thinks - Are rolling leaps an effective way to leverage a position in broadly diversified index etfs?
Leverage? It's okay. But that also means buying volatility exposure (including benefit/protection from extreme moves), so it sounds painfully expensive without a serious plan to manage these factors over time.
If someone really wants leverage on an index, futures may be more direct (eg, buy the contract, leave some cash for margin, invest any remainder in some riskless asset).
Or a very deep ITM long European call option (to tweak how much leverage, interest rate exposure, etc). But you may need to wiggle into to position due to the large bid-ask spread.
Or sell a box spread and use the proceeds to buy the equity exposure (eg, ETF shares)
I'm also assuming "LEAPS" implies equity options (ie, American style which will also tend to cost more).
My main point is: for someone just wanting leverage, why pay more for expensive, unnecessary volatility exposure and limited loss protection?
@@OurNewestMember thanks for the thought out response. 👍
covered call etfs usually sell ATM options though, and these don't have any higher moments
I see JEPI euphoria everywhere
I've gone in on Covered Call ETF's because I'm in a part of my life where monthly income is more valuable to be than total return. I'm pretty happy with how things have gone to this point and can only hope it continues.
Total return is what matters. “Income” is the same as just selling parts of your total portfolio.
Income never matters more that total return. Total returns put food on the table. Income is a mental account.
@@steftrando My income matters to me in retirement regardless of total return if that's a better way for you to look at it.
@@BenFelixCSI Not if you weren't financially literate for your youth and find yourself in retirement needing a steady...ish income. If I were to do it all again, I'd of course look to total return but as I said, I'm in a part of life where income is more valuable to me now than any potential future total returns.
@@aaronhall5715 just sell shares if you need income?
Covered call writing requires active management - given the implied vol vs historical vol, liquidity and sentiment of the market, you need to choose the appropriate strike, tenor and underlying. It can be alpha generating but takes a lot of work! I am not sure if passive ETF is the right way to go for covered call writing