Selling your expertise in options

Covered-call writing is the most common “low-risk” theme promoted by advisors. Options-writing strategies produce cash flow, and there are reams of data that tell us most options expire worthless. So, why wouldn’t it work? There also is ample evidence supporting the long-term success of covered-call writing over various market cycles. In fact, the Montreal Exchange’s covered-call writers’ index (MCWX), which writes one-month at-the-money calls against an underlying position in iShares S&P/TSX 60 Index Fund, is an excellent case study.

The MCWX has data going back to 1993. And, for the past 20 years, this index has outperformed buy-and-hold strategies with less inherent risk. In fact, the MCWX has generated better long-term returns than buy-and-hold without accounting for risk. That’s probably because the S&P/TSX 60 index has been hobbled by overweighted positions in precious metals, commodities and energy.

These are excellent statistics, but they do not prove that covered-call writing always works. The only thing they prove is that over long periods, the strategy delivers alpha when measured against buy-and-hold. In fact, covered-call writing has as much to do with the performance of the underlying stock as with the sale of covered calls. When the underlying stock declines, the covered-call strategy will lose money. That the strategy loses less than it would have, had the calls not been sold, is incidental. But explaining to your clients that they lost less is not likely to assuage their anger.

Still, if you want to espouse a strategy with a long history of success, covered-call writing is a good place to start. The problem comes when you follow that same “low-risk” approach with more complex options-writing strategies that do not involve a long position in the underlying stock.

Not only are such strategies harder to explain, they can cause enormous losses if your clients are on the wrong side of a trade over short periods. Uncovered (a.k.a. naked) put writing is a case in point. Selling puts to acquire an underlying stock has the same risk/reward characteristics as the covered call. That said, naked put writing requires margin, which, in a major sell-off, could force your client to close out a position because of a margin call.

There also are risks associated with a spike in volatility, which would cause the puts to lose value.

These risks are not germane to covered calls, assuming your client has not used margin to purchase the underlying shares.

Selling uncovered straddles (expiry dates and strike prices of both the call and the put are the same) or strangles (same expiry dates but differing strike prices) are other strategies. Short straddles or strangles are volatility trades in which clients are betting that the underlying shares or index will trade in a range bound by the strike price of the call and the put.

The logic underpinning volatility strategies is that most of the time, markets trade in a relatively narrow range interspersed with sharp moves either up or down. But when dealing with uncovered options, short-term bursts typically result in large losses.

The challenge is in the many nuances that go into pricing volatility – by nature, a sentiment indicator. Try explaining fear and greed to a client when their short straddle loses money because volatility spikes. In the end, a short uncovered straddle and strangle is a bad combination with the potential for unlimited losses.

If you are intent on marketing your options expertise, stick with strategies in which the losses are limited. Recognize that most clients are not savvy regarding options and often have no understanding of volatility. Clients are more likely to make decisions based on fear and greed, which never works out well for you.

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