Covered call writing is an options strategy with many benefits, the two most important being the tax-advantaged cash flow (in which options premium income is taxed as a capital gain) and risk reduction.

The tax-advantaged cash flow means that covered call writing is an alternative income strategy, although not a fixed-income strategy. I say this because some clients believe this strategy is a bond alternative — it is not. Bonds have a fixed payment stream and, assuming they are investment-grade, a fixed date at which the principal is repaid.

There has been no better example of this disparity in strategies than the performance of covered call writing vs fixed-income over the past four years. And, frankly — barring some shorter-term exceptions — the same could be said about the strategy from 2000 to today, during which bonds clearly outperformed covered call writing.

This is an important consideration for advisors because the success of any investment strategy comes down to managing expectations. To reap the benefits of any strategy, you have to stay with the strategy long enough for it to pay off.

Covered call writing is an equities-based strategy that, over the long term, should produce returns that are better than you would get with pure bonds — certainly, on an after-tax basis. But not always, as we saw last year, when covered call writing lost 22.91% while bonds actually produced a positive return.

The point is that advisors who want to market this options strategy should focus on the argument that covered calls can produce longer-term, higher tax-advantaged returns vs a fixed-income model.

On the other hand, covered call writing is a lower-risk equities-based strategy, which means that you have less risk in writing covered calls against an equity position than you would have with the relevant pure equity position. In fact, the covered call strategy has actually produced positive alpha (better risk-adjusted returns than you would get by simply holding the underlying equity position) over the long term relative to a pure “buy and hold” equities strategy.

My preference for covered calls is rooted in the positive alpha, because there is ample evidence of positive alpha over the long term. For example, the MX covered call writers index (symbol: MCWX), which measures the performance of a passive covered call writing program on iShares S&P/TSX 60 index fund (XIU) supports the positive alpha argument. Since 1993, when the Montreal Exchange began to measure the MCWX, it has not only outperformed a “buy and hold” strategy, it has done so with less risk. (See the chart at www.m-x.ca/indicesmx_mcwx_en.php.)

The bottom line is that as long as you market covered call writing as an alternative to “buy and hold,” your clients have a clearer understanding of the associated risk, and thus are more likely to remain invested.

Having said that, covered call writing is not always the best options strategy. In fact, it rarely produces the best return in any given year, particularly when compared with other basic strategies such as put buying, call buying, straddle buys and uncovered call writing.

To prove this point, I examined the performance of covered call writing vs the other options strategies in 2008. In fact, covered call writing was the worst-performing options strategy during the period.

My study looked at the 12 options expiration dates in 2008. (The first entry date actually occurred on Dec. 24, 2007; and the last expiration date in 2008 was Dec. 19.) In each case, I assumed that the client entered an options position on the Monday following an expiration and held that position to its expiration.

The results are interesting. At the top of the list is put buying, which returned 85.48%.

Straddle buying (buying one-month, at-the-money calls and puts on XIU) was the second-best strategy, with a 39.08% return. That’s interesting, given that straddle buying is a volatility play. As a result of the extreme levels of volatility seen during the year, the cost of buying straddles was significant. What this tells us is that despite high levels of implied volatility, the options market actually understated the actual level of volatility during the year.

And even call buying, which was not successful, did much better than covered call writing.

Normally, with options premiums at such high levels, you would opt for options writing strategies. But, last year, such a move would have underperformed. That said, we can take solace from the positive alpha argument — despite the negative implications. That’s because covered call writing still did better than holding XIU, which lost 35.4%. IE