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2. The covered call: what you are really selling

Derivatives 5: Hedges and strategies

We stay with the same portfolio: 200 units of the ETF, still at 500 dollars, and two contracts that cover it entirely. Now, instead of buying protection, we are going to sell it. The trade is called a covered call and it is sold, in advertising and in talk shows, as a conservative way of squeezing income out of a portfolio. It is a description that holds up badly as soon as you do the sums.

What you are signing when you sell the call

You sell somebody else the right to buy your units from you at a fixed price. Suppose a call with a strike of 525 — 5% above the current price — at three months, with an assumed premium of 6 dollars a unit. You take in 600 dollars a contract, 1,200 in total: 1.2% of the portfolio collected today. It is called covered because, if you are exercised, you deliver shares you already hold; you do not have to go out and buy them at whatever price is going.

In exchange for those 1,200 dollars you have signed a waiver: everything the ETF rises above 525 stops being yours.

The four scenarios, with numbers

The profile nobody draws but which is worth picturing

Your maximum gain is walled in at 6,200 dollars, whatever happens on the upside. Your maximum loss is still almost the whole portfolio, less the 1,200 collected. That is: you have cut off the right tail and kept the left one almost intact. That is the real asymmetry, and it is exactly the opposite of the one a protective put buys.

There is a cleaner way of seeing it, and it comes straight out of put-call parity: a long share plus a short call of the same strike has the same payoff profile as a short put of that same strike, plus a cash position. It is not an analogy; it is an identity. Whoever sells covered calls systematically is selling puts systematically, under a different label and with less psychological discomfort. The trade is respectable, but calling it conservative while regarding the equivalent selling of puts as reckless is a labeling problem, not a risk one.

Why the right tail matters so much

The stock market's historical return is not spread evenly: it concentrates in short, violent stretches. Truncating those stretches, even if you collect a premium every quarter, means giving up the part of the return that weighs most. The indices tracking the systematic selling of calls on the S&P 500 tend to show slightly lower volatility than the index and a similar or lower cumulative return, with clearly worse behavior in strong bull markets and only marginally better behavior in sideways ones. That profile is the expected one: you have sold volatility, and sold volatility pays little by little and charges all at once.

Two costs that do not show up in the premium

Before the sums it is worth flagging two frictions the advertising leaves out.

The first is managing the winning position. If the ETF rises and the call goes into the money, you have two ways out: let yourself be assigned, or buy it back and sell it again higher up. Buying it back costs money exactly when it is dearest, and rolling the position postpones the waiver, it does not cancel it.

The second is the tax toll. An assignment is a sale, and a sale at a gain is taxed. Whoever sells calls on a heavily appreciated position risks the strategy forcing him to crystallize a gain he did not want to crystallize yet.

The year that explains everything

Let us work through a full year with the strategy repeated each quarter, always selling a call 5% out of the money. The premiums are assumptions consistent with moderate implied volatility. To keep it simple, when the call ends in the money we settle it at its intrinsic value.

Total: 74.7 dollars a unit, 14,940 dollars on the 100,000 portfolio. 14.9%. The ETF, meanwhile, has gone from 500 to 620: 24%. You collected 5,340 dollars in premiums over the year and paid 14,400 on calls exercised. Net balance of the strategy: 9,060 dollars less than doing nothing.

Notice the most instructive detail: all four quarters were profitable bar the last, and even so the year was clearly worse. It is the typical pattern of selling volatility. You almost always make a little and you lose all at once when the market does precisely what you were hoping it would not. The covered call is neither good nor bad; it is a very specific exchange of upside for income, and the price of that exchange is measured in the few quarters when the market runs.

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