By writing out-of-the-money call options, the investor’s upside is capped at the level of the strike. However, the premium the investor earns from selling the option can be attractive if they feel the underlying stock price is unlikely to rally during the life of the trade.
“More and more people are happy to bet against the market trading very strongly and, with current levels of volatility, investors are quite happy to cap their upside if it means they can raise some premium to outperform the downside,” said Cyril Levy Marchall, head of equity derivatives flow trading at JP Morgan in London. “Furthermore, particularly during recessionary periods, upside calls tend to be overpriced compared with upside returns, which makes overwriting quite an attractive strategy for investors.”
Implied volatilities have soared since the third quarter of last year in the wake of the US subprime mortgage crisis. This means investors are able to earn significantly higher premiums through selling options. For example, a three-month 105% call on Deutsche Bank would have earned the writer of the option 2% on March 26, 2006. One year on, the same call would have paid 4.3%.
“As volatility has increased, the yield an investor can obtain from overwriting strategies has increased significantly, with some two- to three-month call options offering 6% and up,” said Gerry Fowler, director of trading floor multi-strategy at Citi in London.
JP Morgan advocates selling short-dated covered calls as a good way to capture the volatility premium and realise yield enhancement on an equity portfolio. Based on an expected slowdown in economic growth and lower upside potential for equities, the bank expects short call strategies on the Dow Jones Eurostoxx 50 index to perform relatively well. Over the past 12 months, for example, a strategy of systematically selling non-delta-hedged Dow Jones Eurostoxx 50 one-month 103% calls would have resulted in an average profit of around 3.7%.
However, not everyone is convinced, noting that, in the current volatile environment, stocks could spike upwards. “A lot of managers are more concerned with bigger risks and profit-and-loss swings in their portfolios. I doubt single-stock call overwriting is very popular as the markets are so volatile right now,” said a London-based hedge fund manager.
Indeed, as Fowler conceded: “Investors are careful to only implement this strategy selectively on stocks they do not believe will rally much further, such as oil.” They are also more careful to move their strikes further out of the money. “A few years ago, investors would choose strikes that were very close to the money because that was the only way for them to get a decent premium. Today, investors tend to prefer higher strikes, in the range of 110–115%. They don’t mind getting a smaller premium if it means they will not be called,” said Fowler.
Société Générale currently advises overwriters to focus on defensive stocks, such as telecoms, basic materials, or food and beverage companies, which tend to be less affected by market volatility.
“In the case of a market rebound, defensive stocks would not gain as much as distressed stocks or growth stocks, which would give the investor time to change the strike of their overwriting strategy or unwind it altogether. Equally, if the market deteriorates further, defensives are likely to outperform other stocks,” said Arnaud Joubert, head of research at Société Générale Corporate and Investment Banking in Paris.
A three-month out-of-the-money call on UK telephone company Vodafone with a 105% strike currently pays a 4.7% premium, with sector volatility in the telecommunications sector hovering around 32%. One year ago, volatility stood at around 22%, and the same call would have paid a 3.5% premium.
For some investors, however, stock prices at current lows are best left alone. “While asset managers continue their usual business of overwriting one- to three-month calls with 100-105% strikes, insurers are actually slowing down their overwriting operations to avoid realising losses,” said Joubert. “If they’ve bought stock at high levels in the past and these stocks have dropped in the past months, an overwriting strategy could see them sell stocks at a strike price that is far below their initial entry price in the stock.”