This Stock Market Ain’t No Field of Dreams You Know!

Options Solutions COO Steven Sears sits down with Andrew Wilkinson to outline his approach to a covered call strategy for equity portfolios.

Contact Information: 

https://optionssolutions.com/

ssears@optionssolutions.com

Note: Any performance figures mentioned in this podcast are as of the date of recording (April 10, 2023).

Summary – IBKR Podcasts Ep. 70

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome to today’s IBKR podcast with me, Andrew Wilkinson. This week’s guest has a rich career history in the options industry as an investor, exchange executive and journalist. He is Steve Sears, who today is President, Chief Operating Officer and co-founder of Options Solutions. So, a huge welcome to Steve Sears. This week’s discussion is going to center around those conservative options, strategies that you use to help clients enhance stock returns and reduce risk. So first of all, please outline for the audience the component pieces to a covered call strategy. 

Steven Sears

The covered call strategy is really one of the building blocks of the equity markets. It involves nothing more complex than owning a stock, ideally a blue chip stock that pays a dividend and then selling a call with a strike price that’s higher than the stock price. Why do you do that? You do that to generate income by virtue of the call premium and you do it to reduce risk because the money received for selling a call also serves as a slight hedge against the stock’s decline. One of the things that we love about the strategy, and that we don’t think enough people truly realize, is that the common stock dividend represents about 46 to 50% of historical stock return depending on the time period in which you manage and which you measure. So, if you seek to use options strategies in this simple conservative way to enhance returns, you actually can add a very important boost to your performance without taking on crazy risk. 

Andrew Wilkinson

Explain to the audience then when does a covered call strategy work best? What’s the optimal type of market? 

Steven Sears

The optimal type of market or stock performance would be a flat or sideways market, or one that is gently rising. The strategy becomes more complicated for people to use in a market in which stock prices are surging higher, and everybody can look back and identify those moments in time within their own portfolios, with their own positions. I saw some data today, I believe that said, the average stock in the S&P 500 is up 1% year-to-date. And the S&P 500 index in fact, would not be up the 7% or so that it is now in early April if not for a handful of stocks. So, one of the things that investors can use to manage the covered call program should they seek to make it a fixture of their discipline, is to be very mindful of when the strategy works best and when it doesn’t. It’s this misnomer that you have to cover the entire position. In fact, you don’t, and there’s a lot of opportunity to maintain what we like to call dry powder, which is by not covering the entire position, and adjusting your strategy to market conditions. 

Andrew Wilkinson

Well, that’s a nice segue into the next question, which is about the fact that recent history has made it very difficult for investors. Are there different types of bear market and what level of bearishness can a covered call strategy withstand? 

Steven Sears

By bearishness what do you mean like you mean the stock market going down or …? 

Andrew Wilkinson

The the last couple of years have been very challenging for the equity market. So, owning stocks in a bear market is not comfortable, right? 

Steven Sears

Well, I’ll tell you. 

Andrew Wilkinson

How do you manage the covered call strategy? 

Steven Sears

I think that most people in most countries own stocks most of the time. And in fact, owning bonds has historically been not particularly rewarding. So, because rates have been low, now even as rates normalize, we are not seeing a mad dash into bonds. It may happen, but it may not. There’s some demographic factors at work, namely that. 10,000 people in America, for instance, turn 65 each day. They’re underinvested. The greatest prospect of return generally comes from equities, not from bonds, so to tie this back into the covered call strategy, what that means is you have to look at your portfolio in a way that is a little bit different than in the than in the past, which is the options market is not the the end all be all, but neither is the stock market some sort of Field of Dreams where you put a dollar in and it magically turns into 10 so you can use option strategies such as the covered call to enhance certain characteristics of the equity, and I would put forth that you can do it in any market environment. Now you’re always going to have downside risk in stocks. That is a fundamental fact, but a fundamental fact as well is that you can use these conservative strategies to generate income to offset stalled stocks, moribund stocks or even enhance stocks that are that are rallying. It just requires discipline and focus. 

Andrew Wilkinson

So smart investors would like to think that they can outperform the market through superior stock selection. What’s your approach to stock selection for a covered called universe? And what’s the outcome? I’m not necessarily looking for the secret sauce here, Steve. I’m just wondering what you do differently. 

Steven Sears

Well, what we do differently is we manage client accounts that are given to us. So, they may have large, concentrated stock positions because they retired as the heads of major corporations. Or they may have amassed large stock positions just through shrewd financial decision making. We work with every single client to determine what the goals are and that will determine how we manage covered call strategies for those executives. Some people have an extremely low basis, and they don’t want to get called away, for instance. So, what you would do is you would manage with a more conservative delta selection. One of the things that we tend to do, that a lot of people don’t necessarily do, is we stay within the one-month expiration cycle. We like something that in the options market we refer to as theta or time decay which is to say options are wasting assets. They lose a little bit of value as each day passes. We like to try to expose ourselves to that phenomenon and harness it. It’s what we call a fact that’s made truer by time. We manage the strategy called the Volatility King strategy and what that does is it picks up stocks from all 11 sectors of the S&P 500. We then have a rather rigorous quantitative sorting process that goes on. We try to pick about two names from each sector, so we have some sort of representative balance of the S&P 500. And then we do something that I’m not aware of anybody else doing. And then as we look for positive income capture tendencies amongst the options, there is an enormous misperception in the investment community that you want to chase high, sizzling red hot options premiums. Well, there’s a reason why they usually tend to be red, hot and sizzling. That’s because the stocks tend to be rather erratic. So, what we have found, and this is based on almost two decades of study at Goldman Sachs, is that if you look for stocks in which the implied volatility is consistently and persistently higher than realized volatility, that those stocks tend to be better covered call writing candidates and that is exactly what we do. We look at the Volatility King strategy every single month and we rechecked the thesis and so far, the returns are proving to be quite a quite robust. 

Andrew Wilkinson

So, you have you almost have a volatility dial. Is it a good idea to seek out low volatility type stocks as part of that strategy during a bear market? 

Steven Sears

Are you suggesting we’re in a bear market now? 

Andrew Wilkinson

I don’t know where we are right now! 

Steven Sears

What I’m suggesting is that, and I’ve written about this many, many times, is that a lot of the old ways of looking at things and thinking about the financial challenges have become a little moss-backed. And that if investors stop trying to think that they can outfox the market and that they actually can understand the stock market, which very, very few people and firms actually do, that their journey through economic time will be much better. So, what should people do in my opinion? I’ve written about this again and again and again. You focus on financial facts made truer by time. The common stock dividend, for instance, represents 45 to 50% of historical stock performance. Inflation is 3 to 5%, so half the game is focusing on those characteristics which tend to always exist, the other half gets down to stock selection. Now how does one select stocks: Does one put all of their eggs in one basket? Or does one diversify? You know, the common thought is diversification leads to the Holy Grail. But I think for many people, there’s the Warren Buffett like approach. You put your eggs in one basket and you watch that basket. And those stocks have certain characteristics because I think that you can’t really understand the market. Most people can’t understand the economy. Most people don’t really even understand the intricacies of volatility. But what they do understand is that certain companies are extraordinarily well run, they’re stable, they have certain characteristics that lend themselves to compounding, which Einstein, as you know, said was the 8th wonder of the world. And if you focus on these facts, which are rather prosaic and not that exciting, and don’t generate a lot of headlines anywhere, most people will tend to do much better than those people who are constantly darting in and out of the market. There’s really no such thing anymore as a long-term investor. People think they’re long-term investors, but in fact that describes how much time they spend in the market. It doesn’t mean that they spend that much time owning one stock and curating it. So, if you can curate your stock portfolio, and it’s not for everybody, with a variety of option strategies designed to enhance those financial facts, made truer by time, I think it can get to be a very interesting outcome. 

Andrew Wilkinson

Thanks to my guest, Steve Sears, President, CEO and co-founder of Option Solutions. You can read more from Steve at Barrons.com, where he still authors The Striking Price column with a focus on options. We carry many of those pieces too on our own Traders’ Insight where you can find us at IBKR. Campus.com, thanks for joining us. Thank you, Steve.