Equity markets are volatile to varying degrees over time and, as a result, expose investors to significant downside risk. Selling call options on stocks held in a portfolio is a way to generate income, reduce downside risk and benefit from that volatility.

Forgo some upside in exchange for income and downside cushion
Covered call overwriting strategies systematically sell short-dated call options on portfolio holdings. The seller of a call option earns the option premium which can add an income stream to their portfolio. Furthermore, selling call options on held stocks tends to reduce the portfolio's overall sensitivity to the market, thereby reducing downside risk somewhat. In exchange for the additional income and the downside cushion, the call overlay will limit the upside participation of the portfolio.

For our Equity Income strategies, we sell call options on single stocks held in the respective portfolios. Selling stock options instead of index options helps minimize basis risk and the risk of being net short any of the stock-plus-short-call combinations. Those call options usually have a tenure of one month and are rolled on expiry. Typically, options are held until expiry and replaced by selling new call options. The strike price is normally set at a minimum of 105%, so that each holding should have an upside participation of at least 5% during the life of the respective option.

Covered call strategy at maturity

The option premium income is a function of the underlying's implied volatility. The higher the implied volatility, the higher the premium that can be earned from selling optionality. As volatilities tend to spike in times of distress, selling call options tends to provide more income in bear markets and thus provide some degree of downside cushioning. For instance, during the Global Financial Crisis, option premia would have been 3 or 4 times greater, compared to a normal environment. High implied volatilities also give the option overlay portfolio manager more leeway to earn a decent premium income and set a higher strike price, so the portfolio could benefit to a larger degree from a potentially V-shaped rebound after a sharp drawdown.

Option overlay benefits especially in down markets
The option overlay is expected to contribute differently depending on the general market environment. While call options sold will generate premium income in all market environments, those options' contribution to the portfolio's return will depend on whether they end in- or out-of-the-money. In strongly rising markets, it is likely that a number of stocks went up by more than the strike level, thus options may end in-the-money and the seller has to compensate the buyer of the option. In sideways markets, results can vary. In case of strongly diverting individual stock returns, there is a chance options end in-the-money. In case of low stock return dispersion, the call overlay is likely making a positive contribution. As markets fall, the probability of the call overlay contributing positively is very high as most if not all options end out-of-the-money. This is when a call overlay will be most beneficial for investors.

Expected performance in different market scenarios

Eventually, this should lead to better risk-adjusted returns for the portfolio
Selling optionality is a way to generate income as well as to capture and monetise implied volatility. Being short call options on stocks held in the portfolio leads to the sacrifice of some of the upside potential in exchange for a premium income and a downside cushion. This should lead to lower portfolio volatility and better risk-adjusted returns over the long term.

Urs Raebsamen, Senior Equity Specialist