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.
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 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 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.
|Market Action||VQT action||SPY call credit spread action||Overall Profit|
|S&P 500 strongly up||Up, but not as much as S&P||Worst case loss. Loss is premium received at creation minus $2/ option pair||Neutral to small loss|
|S&P 500 up||Up, but not as much as S&P||Neutral to profitable, with profit equal to premium received at creation minus any in-the-money intrinsic value.||Modest profit|
|S&P 500 down||Down, but not as much as S&P||Profitable, keep full premium received at creation||Neutral to small loss|
|S&P 500 strongly down||Strongly up as volatility portion kicks in||Profitable, keep full premium received at creation||Very Profitable|
The spreadsheet that provides the VQT backtest data from March 2004, including all formulas is available here.