A Covered Call That’s Long Volatility

Covered calls are an example of  positions that are short volatility.  I hadn’t thought of it that way until Sheldon Natenburg, the author of Option Volatility & Pricing  pointed that out in a fascinating interview in Expiring Monthly  (http://tinyurl.com/6wwplf9).   A covered call position is profitable if the underlying equity stays the same or goes up, but in a big market downswing, when volatility spikes up,  the modest potential profits from a covered call are more than wiped out by the losses in the underlying.

Unfortunately it is usually expensive to hedge a short volatility position.  The two most common strategies have problems:  VXX typically has roll yield losses, and VIX/VXX options have significant time decay.  Recently I started looking at Barclays’ VQT ETN, a fund that is intended to be long volatility.  The chart below compares $1000 invested in SPY and VQT starting in September 3rd, 2010—VQT inception date.

$1k investment in SPY and VQT

In bull market phases VQT underperformed the S&P 500  by about 50%,  but during the -19.5%  drawdown in August 2011 VQT only dropped 3% before going on a short term volatility fueled binge that lifted it 20%.    The next chart shows the day-to-day percentage moves of VQT vs SPY since June 2011.

When times are volatile, VQT shifts its investments to include more short term volatility—which lowers its correlation to the S&P 500 to about 50% or 60%.  In very quiet times, like the end of December/January VQT shifts to a almost pure S&P play—giving it the nearly 100% correlation you see at the right side of the chart.   The next chart is from the VQT prospectus, showing the backtested, theoretical performance of VQT since 2005

VQT vs S&P500 backtest to 2005

VQT looks almost tailor-made for covered call writing.  Its low drawdown behavior limits capital risk while its volatility is similar to the S&P 500.  Unfortunately, there are no liquid options available on VQT, so we’ll have to get creative in developing a covered call style position.  Since much of VQT’s composition is direct exposure to the S&P 500 I will use SPY options as logical building blocks.  A covered call is a short call position hedged with a long equity position.    Since brokers won’t accept a long VQT position as a hedge for a short SPY call and I don’t want to have naked calls, I’ll protect my short call position with long out-of-the-money calls—creating a call spread.     I’m not too concerned about losses on these credit spreads, because VQT is a natural hedge for the position, so I’m comfortable with a $2 spread in the option strike prices.

Profitability analysis:

The spreadsheet that provides the VQT backtest data from March 2004, including all formulas is available here.