In the offices of banks, fund management companies and other financial services providers, staff calculate, analyse and forecast round the clock to find the right asset structure for their clients’ money. The professionals are trying to find the appropriate investment strategy for the particular market environment. The “call overwriting” strategy has recently gained in attractiveness. It involves taking a position in a share while at the same time writing a call option. Corrections in the share price are mitigated by the income generated by the sale of calls, but the upside potential is limited by this same option. A call overwriting strategy thus swaps some of the potential share price gains for the certainty of an immediate income payment.
The strategy fits perfectly with the current age. For many years the politics of cheap money ensured that equity markets climbed dynamically upwards. At the moment, though, central banks are moving in the opposite direction. To combat inflation, the monetary watchdogs are tightening the interest rate screw. The markets will probably remain in this environment for some time to come, which presents a huge challenge for investors. That is because the last few months have shown that prices react to changing realities with extreme volatility. This is exacerbated by economic and geopolitical risks, which increase the likelihood of an enduring period with rather muted overall returns on the equity markets. It is in times such as these that the call overwriting strategy proves its merits: firstly, it can deliver an outperformance when markets are treading water. Secondly, it sells volatility, which is often at an elevated level given an uncertain environment.
A historic analysis by asset management company Schroders between 2000 and 2022 underlines the effectiveness of the sophisticated concept. The analysis considered an S&P 500 equity model with call overwriting aiming to achieve a premium of 3.6% p.a. and compared it against the classic S&P 500 Index. Although the strategy did not stand a chance at times of huge rises, such as when the S&P 500 more than doubled from 2012 to the start of 2018, the call overwriting strategy generated a positive effect in most 12-month periods since the turn of the millennium. In percentage terms, the strategy would actually have exceeded the index in 73% of the rolling 12-month periods.
Option strategies are relatively complicated for many private investors, and the risks are hard to assess. The world of structured products offers a remedy, however. The reverse convertibles (RC) that are known and also very popular here are equivalent in economic terms to holding shares and selling calls. While the payout profile of RCs corresponds to that of the call overwriting strategy, the “design” of the product is not identical. In a reverse convertible, a zero bond is purchased and a put option on the underlying is sold at the same time. In both cases, however, the result is the same: on the one hand the investor profits from the proceeds generated by the sale of the option, but on the other the chance of a return ends at the strike price of the option. If the price of the underlying rises well above the strike, the holder no longer participates on the upside. However, holders of the product can rely on receiving the premium from the sale of the put option through periodic coupons. The option premium – and hence also the amount of the interest payment – is influenced by the expected variability of the underlying, known in the trade as “implicit volatility”. The rule of thumb here is that the higher the volatility, the higher the coupon. This is explained by the fact that a greater variability increases the likelihood that the price of the underlying will be lower than the strike price on the valuation day, so that the put option is exercised. In this case the holders would receive the share at the end of the term. The guaranteed interest payment cushions possible price losses, however.
Source: SIX
