I've Got You Covered

Before I get to those, here's a quick review of call options. A call option represents the right to buy an underlying asset at a particular price, known as the strike price, anytime before an expiration date. The call buyer has the right to make the purchase, and the call seller sells that right and must take the other side of the trade if the option is exercised. Selling a call is often referred to as writing a call. So if you sell one contract of the XYZ December $25 call, for example, you must be prepared to deliver 100 shares of XYZ at $25 a share to the buyer of the call anytime before the third Friday in December.

In exchange for that obligation, the call seller receives an option premium; that is, an upfront cash payment paid by the buyer of the call option. The seller keeps the premium no matter what happens with the option or the underlying stock. A call is considered "covered" when the seller of the option owns the underlying stock.

A major benefit of covered calls, also known as buy-writes, is income generation. Beyond dividends, simply owning a stock in a trendless market produces little profit. But if you're long XYZ at $23 and sell the December $25 call for a $1 premium, then you've immediately cut your cost to $22. And because options usually expire without being exercised, you can theoretically sell a number of covered calls in a year's time.

Just like the cash-secured puts I wrote about a few months back, I believe a drawback of covered calls is that too often you end up missing the big moves — exactly where the real market gravy is made. While the strategy produces an immediate credit (the premium), your upside is limited should the stock rise above the strike price. If you buy XYZ at $23 and sell an XYZ December $25 call, it doesn't benefit you if XYZ goes to $50. As long as you're short the call, you'll be obligated to sell your shares at $25 until the call expires.

In my mind, you end up with much of the risk with very little of the potential reward. With covered calls, I find those few times I'm lucky enough to buy a stock that rises 100% I inevitably end up capping my upside at a measly 15% or so.

Of course, stocks also fall. And when they do, the premium earned in selling a call is a pittance compared with the potential loss on the underlying stock. Covered calls aren't always a hedge. You end up making $1.25 on an option only to lose $5 on the stock itself.

Selling option premium is often compared to being in the insurance business: The real value comes not from selling one call, but in the regularity of premium payments collected over time. To that end, proponents of covered calls have pointed to academic research that suggests the strategy is best used as an asset-allocation decision, not simply a way to "play" a particular stock.

In 2002, the Chicago Board Options Exchange created the S&P 500 BuyWrite index, or BXM, a passive, total-return index based on selling the near-term, near-the-money S&P 500 Index call option against the S&P 500 stock index portfolio each month. The short call has approximately one month remaining to expiration, with an exercise price that's just slightly out of the money. The BXM offers an easy reference of how a covered-call approach is faring compared to other strategies or the market overall.

The data suggest that, if you own the major indexes, adding a systematic covered-call allocation not only can boost your returns, but offer a smoother ride along the way. According to a 2004 study by Ibbotson Associates, an investment-research firm, the BXM index outperformed the long-only S&P 500 over a 16-year period, achieving a compound annual return of 12.39% vs. 12.20% for the S&P 500. A dollar invested into the S&P 500 on June 1, 1988, was worth $6.19 by April 2004. The same investment in the BXM, however, would've been worth $6.36.

The real attraction is that the returns were better and they were achieved with significantly less volatility than a traditional long-only portfolio. From June 1988 through December 2002, the annualized standard deviation of returns — a measure of volatility — was 14.9% for the S&P 500 and 10.0% for BXM.

Essentially, the S&P 500 significantly outperformed the BXM during the bull market of the late 1990s, but gave up a large percentage of its gains during a few months of the early 2000s bear market, when a buy-write approach garnered a significant advantage.

Not surprisingly, a smattering of new funds has sprung up with covered calls as an integral part of their strategy. In 2005, more than $14 billion has been invested into more than 30 funds and structured products using a covered-call strategy. Designed to appeal to income-oriented investors, most pay monthly dividends and currently offer yields in the high single digits.

S&P 500 Covered Call (BEP), for example, closely tracks the CBOE's BXM, less expenses. At $18, the fund yields more than 11% and trades at a slight discount to its net asset value. Enhanced S&P 500 Covered Call (BEO), which debuted in September, offers a leveraged play on the buy-write strategy. It trades at a 5.3% discount to NAV, but hasn't yet paid its first dividend.

Another breed of closed-end products is represented by funds like Eaton Vance Enhanced Equity Income (EOI) and Madison/Claymore Covered Call (MCN), which use a buy-write strategy with active stock selection in lieu of simply replicating the S&P 500. The Madison fund's top three holdings, for example, are Home Depot (HD), Bed Bath & Beyond (BBBY) and the Nasdaq 100 Trust (QQQQ), an exchange-traded fund. With the fund at $14.80, the dividend, paid quarterly, currently stands at 8.91%.

And even with the S&P 500 at a new four-and-a-half-year high, it's likely the growing interest in covered calls isn't over yet. The CBOE has recently launched the NASDAQ-100 BuyWrite Index, or BXN and the CBOE DJIA BuyWrite Index, or BXD, extending the strategy's benchmarks to include the two other widely watched indexes. Given the sheer number of near-retirees now searching for income securities not directly correlated with changes in interest rates, it looks as if the strategy will likely attract more investor interest for some time to come.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in some of the securities mentioned in this article.