The very thought of stock options can strike terror in the heart of a typical buy-and-hold investor. “Too risky,” is the common reaction from the underinformed.

But why would investors harbor that irrational fear? Because Wall Street money managers earn billions by discouraging clients from directing their own investments and taking advantage of options. 

To investors, that represents lost opportunity, or dare one say it, lost optionality. Proactive investors who use covered call options (sometimes called buy-writes) actually take less risk than they would passively buying and holding a stock. In fact, for the past 26 years properly implemented covered calls have had half the largest annual drawdown of a passive buy-and-hold methodology.

How can covered calls reduce drawdowns by nearly half? What’s the catch? There isn’t one. It’s a transfer of risk. Investors are gaining downside protection and increasing their chances of making a profit in exchange for giving up a bit of upside potential when the stock price increases.

Over time, the credits received by writing calls against a stock position can reduce its breakeven. Do it long enough, and breakeven can theoretically go to zero. 

Think of it this way – if an investor bought a stock for $0, how much risk does it have? $0. That stock can only go up and make money. So, the lower the cost (or breakeven point) of a stock, the better. One of the most effective ways to lower the cost is to sell calls against a stock. Take a look at “Covered call credits,” above. If investors used that strategy during the last three months of 2018, each time the call was sold, they would have reduced the position’s breakeven by an average of 1.4%. 

A 1.4% reduction in the breakeven may not seem like much, but that’s for only one month. Now consider that the dividend yield on the S&P 500 is a little under 2% for the entire year. Some stocks and exchange-traded funds (ETFs) make money on selling the call of up to 3% or more of the price of the stock per month.

That can amount to a breakeven reduction of 25% to 50% per year! The money from selling covered calls is credited directly to the investor’s account. Traditionally, investors have referred to the covered call as “income producing strategies.” Think of it as a way to reduce the stock’s risk and breakeven point in exchange for giving up some upside potential that might have a low probability of happening anyway.

Now, opponents of covered calls argue that buy-and-hold investors have had average returns of 13% per year – so why bother doing anything else? But that number is outdated – returns are closer to 6% since 2000.

To put that in statistical terms, the gain using covered calls is approximately 67% as great as with the passive approach, yet the losses are 50% of the passive buy-and-hold methodology. Look at the results shown in the table that appears below.

The level of daily or monthly fluctuation within an account is especially important to those seeking a bit more account stability. That’s not “explained” by just looking at the average return of two strategies. Given the choice between two hypothetical funds with the same amount of risk, most prefer the fund with the higher average return. For example, investors who look at “The impact of volatility” in the table below usually choose Fund A. That’s because the average return is 6% in Fund A compared with 5% for Fund B.

But investors in Fund A will end with a slightly lower balance than in Fund B – even though the average return of Fund A was greater. That’s because the yearly swings and drawdowns in Fund A were greater than Fund B. That volatility reduced overall returns. When investing, remain cognizant of returns and the volatility of those returns. 

Averages alone are difficult to use as comparisons. And that is one of the big advantages of proactive strategies like the covered call – the reduction of the monthly swings (i.e., lower volatility) in the account balance. For retirees or those who need immediate access to cash, the covered call can reduce account balance fluctuations.

Let’s get back to a real-world example. Take a look at the worst drawdowns per year. It is the fear of buying the high every year and then selling at the absolute low. No one wants to be the guy who does that. If investors really knew that drawdowns in the S&P 500 have been as big as 56.5%, many would never put money into funds. These drawdowns are related to volatility – and it’s the reason we have to look at more than just average returns, as readers can see in the table called “Larger downdowns from passive strategy” on page 35.

Now, investors who used a slightly more active approach such as a covered call, had significantly greater stability. Losses weren’t as great – in fact, a covered call strategy has less risk than a passive, buy-and-hold investment philosophy. While the worst drawdown in the passive approach averaged 27.5% since 1993, the drawdown in the active covered call strategy averaged 15.2%.

So put the proactive covered call into practice! First, decide on a stock or ETF that seems worthy of a bullish approach. Some possibilities appear at the left in “Entry point.”

Why are there only ETFs on the list? Index ETFs provide greater diversification and less company-specific risk – in other words, one or more stocks can go bankrupt, and the entire position won’t be lost. ETFs can be a safer choice for first-time investors.

Next, decide upon a level of bullishness to determine what call strike to sell. While covered calls are always bullish strategies, the strike selection is important. The more bullish the assumption, the higher the strike to sell. The more neutral the assumption, the closer to the current price, or closer at-the-money, is the strike to choose. A quick guide appears below in “From theory to practice.”

The numbers speak for themselves. As an individual investor, employing a proactive covered call strategy can make a lot of sense. Lower risk, higher probability of profit and a tighter connection to the portfolio combine to create increased optionality.

Michael Rechenthin, Ph.D., (aka “Dr. Data”) is head of research and data science at tastytrade