When it comes to covered options writing, there are two main benefits: tax-advantaged cash flow, in which the option premium income is taxed as a capital gain; and risk reduction.

The tax-advantaged cash flow means that covered call writing is an income-alternative strategy. It is not a fixed-income strategy. I say that because some investors think 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 five years, a period in which bonds, with a compounded annual return of 5.6%, had clearly outperformed covered call writing, which had a compounded annual return of 3.5%. And, quite frankly, with some shorter-term exceptions, the same could be said about the past 10 years.

Covered call writing is an equities-based strategy that, over the long term, should produce better returns than one would get with pure bonds — certainly on an after-tax basis. But, shorter-term figures can be quite skewed. Take 2008, for example; that year, covered call writing lost 22.1%, while Canadian bonds produced a 3.7% return.

The point is that your clients should focus on the longer-term, higher tax-advantaged return argument — if you’re suggesting to clients that covered call writing might be a useful income-producing strategy to complement their bond holdings.

On the other hand, covered call writing is a lower-risk equities strategy. This means that you have less risk in writing covered calls against an equities position than you have with a pure equities position. In fact, the strategy has actually produced alpha (i.e., better risk-adjusted) returns over the long term vs a pure “buy and hold” equities strategy.

My preference for the covered call writing strategy is rooted in the mountain of evidence supporting the alpha argument. As a case study, the MX covered call writers index (MCWX) measures the performance of a passive covered call writing program on the iShares S&P/TSX 60 index fund (XIU). Since 1993, when the Montreal Exchange started to measure the MCWX, it has not only outperformed a buy-and-hold strategy, it has done so with less risk.

Similar numbers can be found in the U.S., using the Chicago Board Options Exchange’s BXM index, a passive covered call writing strategy on the S&P 500 composite index.

Bottom line: covered call writing is an excellent alternative to “buy and hold.” And as long as your clients have a clear understanding of the associated risks, they are more likely to remain invested.

On the other hand, 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 buying and uncovered call writing.

To make the point, compare the performance of covered call writing vs the other strategies throughout 2009. The comparison looks at the 12 option expiration dates that occurred during 2009. The underlying security for all the strategies was XIU. In each case, it was assumed that the investor entered a position on the Monday following an expiration and held the position to expiration. (The first entry date actually occurred on Dec. 22, 2008; the last expiration date finished on Dec. 18, 2009.)

Covered call writing was a middle-of-the-pack performer, with a 20.2% return. This lagged straddle selling, 57.1%; call buying, 48.4%; and long stocks, 34.7%; but was ahead of straddle buying and put buying, which lost 57.1% and 69.5%, respectively.

The results are interesting. What probably surprises many readers is that selling straddles (selling one-month, at-the-money calls and puts on XIU) was the top-performing strategy.

What this tells us is that, in general during 2009, option premiums overstated the actual volatility that occurred in the market. In other words, despite the fact the market rallied, its major move was in a specific direction. To make straddle buying profitable, the market has to move sharply up or down in the month that each position was held.

Taking that concept a step further, call buying was the second most profitable strategy. Call buying is a directional trade — and its performance reflects the strong rally in Canadian stocks.