We’ve seen that a PutWrite strategy using options on the Nasdaq-100 index (ticker NDX) can generate returns which are similar to the Nasdaq-100 index but which display substantially less risk as measured by volatility of returns.
But some investors have been asking if there is another strategy which is appropriate for those who already own the Nasdaq-100 index yet takes advantage of the benefits of selling options.
The primary advantage of selling options is that, over time, the price realized for selling those options will be greater than the ultimate value of those options. A second advantage is that the inherent diversification increases risk-adjusted return.
The way to mimic a PutWrite and take advantage of this option pricing phenomenon for those who are already long the Nasdaq-100 would be to sell a covered call option.
A covered call is a trade structure wherein you sell a call option against an underlying stock or index you already own. The risk from being short the call option is “covered” by the ownership of the underlying asset, in this case the Nasdaq-100 index. The combined position of long the index and short a covered call is often called a “BuyWrite.”
Generally, the call option sold will be slightly out-of-the-money meaning the strike price of the call option is slightly above where the index is currently trading. If the call option is significantly out-of-the-money then little premium will be generated. As with any option strategy which is selling options, the premium received for selling the covered calls is yours to keep.
The covered call seller is collecting option premium and in return is agreeing to sacrifice all appreciation above the strike price of the call option sold until the option expires. That’s the tradeoff with a covered call, the seller collects option premium which is theirs to keep but agrees to cap the profit on the underlying asset until the option expires, no matter how big the rally. Since the covered call seller gets to keep this premium it generates somewhat of a buffer against loss if the index should fall.
Why would an investor sell a covered call? If the investor thought the index was unlikely to exhibit much movement for the life of the option contract then it would make sense to sell a covered call. If an investor thought there was substantial downside risk then there are other strategies which would be more appropriate. Similarly, if an investor thought the index was likely to rally substantially then selling a covered call wouldn’t be the best strategy.
As an example, the Nasdaq-100 index closed at 8402.61 on Wednesday, December 11. If an investor was long the index and wanted to sell a covered call then they might sell the 8550 strike call option expiring on January 17. That call could have been sold for 88.00 on the close.
The notional value of an NDX option is $100 multiplied by the level of the Nasdaq-100 index or $840,261 so an investor selling an NDX covered call would need a Nasdaq-100 portfolio at least that large for the call to be covered (we would never sell uncovered or “naked” calls) but these principles apply to any index or asset including the Nasdaq-100 Reduced Value Index (ticker NQX) which is just one-fifth the size of the larger NDX.
By selling that 8550 strike call, our investor is willing to forego any gains above a certain level but what is that level? That level for a covered call is the strike price of the call option sold plus the premium received. In our case that would be 8638.00 (8550.00 plus 88.00). Above this level our investor would regret selling the covered call because she has stopped participating in the rally as you can see.
A covered call can be a great strategy because it takes advantage of option pricing and generates extra return when not much return is expected. Thanks to the inherent diversification it can boost risk-adjusted return and offer a buffer against some loss. And since the risk is “covered” it can be appropriate for many investors.
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Performance of an index is not illustrative of any particular investment. Index returns quoted represent past performance which is no guarantee of future results.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.