In the know: Launching US equities covered calls
Yesterday, we presented a brief introduction to covered calls. It is basically a strategy involving owning the underlying stock and selling a call option with a strike above the current price of the underlying stock. The strategy's primary goal is to enhance returns.
The covered call strategy is very popular among investors as it generates extra return by selling volatility on positions that investors do not intend to sell anyway. Long-term selling volatility generates stable returns but is interrupted at times when realised volatility falls significantly outside the implied volatility observed in the options.
Launching US covered calls
To provide clients with the best opportunities to identify stocks that are good at writing call options on, we will publish a weekly US equities covered call table on the most liquid US single stock options. The table will be published on Wednesdays.
The table will include a wealth of information on 40 stocks including our own model's preferred strike level. Based on all the information, we calculate the static return (the annualised return if the underlying stays unchanged) and the called return (the annualised return if the call option is exercised).
Let us go through an example based on the table. AT&T closed at 35.02 yesterday. If investors owning AT&T stocks are willing to sell call options with an expiration at July 10 and a strike price at 36, then 9 cents can be collected. Within expiration, a dividend per share of 46 cents will be collected (see table). Under the assumption that the underlying price does not move, the static annualised return is 13.3 percent.
What is the probability that the underlying price will end above the strike price at 36 within the next 31 days? This is where our model assumptions come into the picture. We assume for simplicity that weekly returns are normally distributed and then use the realised volatility (based on 52 weekly observations) to calculate the threshold returns for 66 percent cumulative probability. In other words, the model's preferred strike price is set such that there is a 34 percent probability that the underlying price will end above the strike price, under the assumption of normal distribution which holds under normal market conditions. However, during intense market stress such as during the financial crisis in 2008 these assumptions did not hold.
Read the full publication including explanations for colour coding and ratios in the attached PDF.