What is call overwriting and why could it prove attractive in an uncertain world?
What is call overwriting and why could it prove attractive in an uncertain world?
This year, the economic stances of governments and central banks around the world have undergone a significant move. They are now combating inflation and reversing the quantitative easing (QE) policies that characterised much of the last decade.
Such a shift means that investors may need to reconsider their positioning as the investment styles that fared well in the past may not work so well in this new environment. Instead, other styles may become more attractive. Call overwriting could be one such example.
What is call overwriting?
Covered call overwriting involves selling a call option on a stock or index that an investor owns. When selling out-the-money call options, the seller retains the potential capital growth up to a certain level (the strike price), but any growth above that level (over a set period of time) is sold in exchange for an upfront payment. (Out-of-the-money means the underlying price of the share or index is currently below the strike price).
In this way, a call overwriting strategy exchanges some potential share price growth for the certainty of an income payment now.
QE provided significant support for shares
It is common knowledge that the advent of the Global Financial Crisis in 2008 prompted an unprecedented shift in global monetary policy. Through lower interest rates and QE, the focus was on stimulating economies and providing liquidity to financial markets.
In the years since, these tools have been called on again and again to help calm financial markets, with interest rates near zero, or negative in the case of the eurozone. In particular, 2020 saw the largest increase in global debt since World War II as policymakers responded to the Covid-19 pandemic.
While calming the nerves of investors at key points, the scale of this intervention provided a significant tailwind to equity markets over the past 12 years. From the low of 9 March 2009 to the high of 3 January 2022, the S&P 500 Index enjoyed a total return of over 800% - an annualised total return of more than 18%.
This rise was not in a straight line. There were sharp corrections along the way, most notably in relation to the global pandemic in March 2020. However, this undoubtedly represented a very strong period for equity returns.
Further evidence of the ability of QE to help support the equity markets and reduce market volatility can be seen in the following table. There has been only one notable negative annualised return for the S&P 500 over this period: 2018, which coincided with a marked contraction in the size of the Federal Reserve’s (Fed) balance sheet.
A different era?
Central banks are now taking a very different outlook, with a drive to raise interest rates to tackle inflation taking precedence over measures to combat slowing growth. According to Fed Chair Jerome Powell, the Fed will do ‘whatever it takes’ to get inflation under control. The response globally has been in the form of progressive interest rate hikes and a reversal of QE. This environment is likely to be with us for some time yet, which presents quite a change in the backdrop for financial markets.
While we continue to see equities as a powerful long run investment, particularly when it comes to income investing, there will be few commentators willing to predict the same outsized total returns for markets in the coming years. Already this year, markets globally have had a very challenging time. As stimulus continues to be removed against a backdrop of economic contraction, an era of more muted overall returns looks far more likely.
Of course, not all equity styles perform equally during periods of higher inflation and economic slowdown. Looking ahead, it will be important for investors to be more selective with their equity allocations.
Research from Schroders’ Multi Asset Team (using their proprietary Global Wave business cycle model) found that high dividend yield, or equity income styles, provided investors some of the strongest returns during those periods categorised historically as slowdowns.
Against this more muted backdrop, we see a good opportunity for call overwriting strategies. The reasons for this are two-fold: 1) call overwriting strategies can add value to equity portfolios when markets are not rallying hard; and 2) call overwriting strategies are effectively sellers of volatility, which has been at elevated levels against an uncertain backdrop.
How would you expect a call overwriting strategy to behave?
One of the better-known behaviours of a call option strategy is that, in fast-rising markets, they could be expected to underperform a similar equity portfolio with no call overwriting strategy. This is because the strategy exchanges some of the potential capital growth in the future for an upfront payment now. This may cap the performance of the portfolio if the stocks rise more than the expected behaviours built into the option price.
If we look at the performance of call overwriting over the past decade, it is therefore not surprising that there have been headwinds, with markets buoyed by QE and low interest rates. In that tough period for call overwriting since 2012, more specifically between 2017 and 2019, equity markets were characterised by particularly strong returns and suppressed levels of volatility.
The chart below demonstrates this. It shows, on a rolling 12-month basis, the theoretical relative performance of an S&P 500 equity model with call overwriting (targeting a premium of 3.6% p.a., see graph for details) versus the S&P 500 Total Return from 2000 to end June 2022 (dark blue line, LHS).
There is a downward trend in the relative performance of the equity model with call overwriting from 2012 to early 2018. This is a period when the S&P more than doubled. However, it is worth noting that most 12-month periods since 2000 have shown a positive effect from call overwriting. If we put this in percentage terms, in 73% of the rolling 12-month periods, the fund with call overwriting would have outperformed the index alone.
A more volatile environment can benefit call overwriting strategies
The second reason we mentioned is that, while the era of QE had the effect of suppressing equity market volatility, the potential reversal of this, along with greater levels of economic and geopolitical uncertainty, has seen heightened levels of volatility return.
As sellers of volatility, call overwriting strategies can be beneficiaries of this backdrop, through harvesting a higher ‘volatility risk premium’ (VRP) which is the difference between expected and realised levels of volatility.
The chart below shows that from 2012 to 2020 the VRP (implied volatility minus realised volatility) of the S&P 500 has been positive, but mostly within a relatively tight range (shown in blue). Since mid- to late-2020, there has been a shift upwards to a more positive level and a wider VRP band (shown in red).
This is because for the same level of option premium, sellers can expect to generate higher strike prices and likely see fewer options expire ‘in-the-money’ (above the strike price/cap). The option premium therefore becomes additive to the performance of the strategy.
When we think about market expectations, potential economic and geopolitical uncertainties and the withdrawal of unprecedented levels of stimulus over the coming months and years, we believe that the conditions are increasingly supportive for call overwriting strategies.
Active management of a call overlay strategy can then help to capitalise on this potentially elevated VRP, by pinpointing pockets of relative value between individual stocks. In doing so, the strategy represents not only a powerful tool to deliver income enhancement, but also a potentially additive contributor in a more challenging total return environment.
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