Educational Programming Video
The Value Line Daily Option Survey
Program 7: Combining Covered Calls With Other Strategies
In our last session we discussed covered calls. In this lesson, we'll discuss risk and combining covered calls with other strategies.
A Few Basic Principles. The first is that there is usually a tradeoff between risk and return. This, of course does not mean that all risky investments will have high returns, or that high-risk investments always beat low-risk ones. Regardless of the tradeoff, however, if you are dependent on maintaining the value of your assets, you should attempt to reduce the volatility of your portfolio as much as possible, keeping in mind your profit objectives.
Our term "Relative Volatility" makes it easy to conceptualize risk. A stock of average risk is said to have a Relative Volatility of 100. At present, this 100 benchmark is equal to an annualized standard deviation of around 32%, while the S&P 500 has a Relative Volatility of around 40. All other stocks and options can then be readily compared to this benchmark. An option with a Relative Volatility of 400 is 4-times as risky as the average stock, while a covered call position with a Relative Volatility of 45 would be less than half as risky as the average stock. Investors' risk is sharply reduced through diversification, among both the underlying stocks and among different option strategies. When investing in stock options, it makes sense to diversify among options with underlying stocks in different industries, since these will tend to have a lower day-to-day correlation. It also helps to diversify among option strategies, as well as among options. While a portfolio that consists entirely of long calls is likely to lose money if the market declines sharply, a portfolio that also includes some short calls is likely to have its losses neutralized. Example: A portfolio of 10 covered call positions will have only about half the risk of one that consists of just one covered call position. The addition of long puts to the portfolio mix will have the effect of reducing this risk still further.
Diversification works especially well when you diversify among different option strategies. Thus, various combinations, such as our "Long/Short" Hedge and other strategies in which bullish and bearish and/or long premium versus short premium strategies are combined, are likely to produce very positive rewards for very reasonable levels of risk. Below is a list of such strategy combinations, with a brief description of their characteristics.
Following Value Line's recommendations, it is possible to structure your portfolio in such a way that will prepare you for an unexpectedly sharp move in the market that might otherwise wipe you out. Naturally, as with all investing, you also must be prepared to live through periods in which you suffer losses.
Covered Call Writing and Combinations
Over the past 19 1/4 years, covered call writing has been a very successful strategy in terms of reward versus risk. It has provided profits averaging over 25% a year (effectively doubling every 3 years) with about the same level of risk as holding a portfolio of common stocks. In addition to being a very strong strategy on its own, covered call writing lends itself very well to combinations with other strategies including put buying, call buying and "naked" call writing - but not to "naked" put writing which is too similar a strategy to covered call writing for effective diversification. For instance, according to our track record, a portfolio consisting of 80% covered calls, 2.5% long puts, 5% long calls and 12.5% margined short calls, produced a return of around 41.0% with a standard deviation that was less than that of the overall stock market. A diversified portfolio of 10 covered call positions and several long call, long put and "naked" short call positions would probably entail a minimum portfolio of at least $50,000, although a portfolio of $100,000 would be closer to the recommended amount.
If you would like to try to optimize your own portfolio allocations, you can do so using our track record spreadsheet; simply e-mail us at firstname.lastname@example.org for a copy.
Thanks for your interest in Value Line. Be sure to spend some time with our other education programs.