Tuesday, April 5, 2011

The risks of buy-write

In the current low yield environment, it is useful to recall the Ray DaVoe quote: "More money has been lost reaching for yield than at the point of a gun." In addition, David Merkel at Aleph Blog wrote a timely blog post on this same topic of reaching for yield:
I have often said that the lure of free money brings out the worst in people. I think that one key area of that is the seeking of yield. I will say it plainly: Wall Street can give you whatever yield you like, if you don’t care about preservation of principal. Yield is the oldest scam in the books.
Wall Street has a wide variety of yield products, and I highlight this now, because we are in a low yield environment, and they will bring these products out more often as a result.
In that spirit, I wrote the Qwest Investment Management April 2011 newsletter called The price paid for stretching for yield.

In the current risk-on but low-yield environment, I have seen a lot of gimmicky vehicles (that usually turn out badly) offered to investors. A great example is the buy-write strategy. Proponents point to charts below that show a buy-write index appears to have outperformed the market with lower volatility.



What gets glossed over is that these strategies are required to continuously sell call options by mandate. If the market suffers a large fall, while the extra income received income received does cushion the decline, it is an uphill battle to make up the loss while having to sell call options. I have reproduced the above chart but with the indices set to 100 at the March 2009 bottom to illustrate my point.



A colleague also pointed out that around 2000 and 2001, a lot of money went into buy-write strategies on the high flying TMT (Tech, Media, Telecom) stocks (e.g. Lucent, Adelphia, etc.) because the option premiums were very high. Sure, investors got extra income, but their capital in many cases went to zero.

In addition, a number of years ago I spoke to a "little old lady" investor who said that she had some money in a fund that yielded 10%, when market yield were in the mid single digits. As a matter of personal interest, I called up her stockbroker and asked how it is the fund was achieving that level of yield. It turned out to be a buy-write fund that was "targeting a yield of 10%".

We all aim for great things. Caveat emptor.

Remember that return OF capital is just as important as return ON capital. In his blog post, Merkel went on to advise against these gimmicky investment products:
My counsel to almost everyone is avoid complex products.  If you can’t get the yield that you need through ordinary vanilla products that are transparent, then either reduce your spending or consume a little capital.  Wall Street and insurance companies thrive on complexity, because you can’t price it or do comparisons.  You are playing their rigged game; they may not be trying to skin you, but just nick you. 
I would amend that advice from "reduce your spending or consume a little capital" to focus on total return instead of just yield or income. Come and read the newsletter in its entirety, where I discuss the pros and cons of various yield enhancement strategies, not just the buy-write.

5 comments:

Mark Wolfinger said...

Buy-write is not a suitable strategy for those seeking increasing yield.

Thus, it's inappropriate to write about the buy-write strategy as a high risk, flawed methodology.

Used correctly, it is one method that PEOPLE WHO WANT TO OWN STOCKS can adopt to provide a small amount of downside protection in the form of an upfront cash premium - in exchange for accepting a limit on possible profits.

This is the method that produces slightly better results with reduced volatility. And for the right (bullish) investor, there is nothing wrong with it.

More conservative investors may prefer strategies with less risk, but there are plenty of people who insist on holding stocks. For them, the buy-write (covered call writing) is appropriate.

This method is not for people seeking yield. It is for equity holders.

Thanks for the fine blog.

Regards

JEFF PARTLOW: THE COVERED CALLS ADVISOR said...

I agree with Mark's comment.
Your perception of buy-writes is misguided. Buy-writes (aka covered calls) are not solely a yield-enhancing investment. I, for one, invest with them as a total-return strategy.

Your characterization in your newsletter article that buy-writes are an "exotic option strategy" is hyperbole. Rather, covered calls are more like a simple stock hedging strategy.

What I love about covered calls is that they offer the potential for slightly better total returns than a buy-and-hold stocks portfolio and with about 30% less risk.

Regards and Best Wishes,
Jeff

Humble Student of the Markets said...

I stand by my comments. Too many times, buy-write has been sold as an income enhancing strategy, which is inappropriat for that purpose.

It is a risk modification strategy, with subtleties and nuances that are not perceived by most of the investing public.

Peter Evanson said...

Am currently learning about trading with Australian Investment Education, the covered call strategy they teach is quite straightforward. I think as any investment strategies that you use, you need to asses your risk levels, and if it’s fit for you. Helps when someone actually talks to you and give you sound advice about your needs instead of their personal interest.

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