Olly Russ

Using the return of volatility to boost income

Olly Russ

Olly Russ - Using the return of volatility to boost income HEADER

Following a long period gathering dust in our metaphorical portfolio management tool-kit, we have recently dug out one of our favourite strategies for providing an income boost: the covered call. This method of income generation is a viable option again as a direct result of the recent pick-up in market volatility.

The covered call is a very simple option strategy. By selling – or ‘overwriting’ – call options on stocks the portfolio owns we receive a premium which generates some extra portfolio income. An environment of severely suppressed volatility over the last year had rendered the covered call strategy fairly impotent, but the European Central Bank’s (ECB) removal of quantitative easing (QE) is now reviving this element of our portfolio.

When operating a covered call overlay on a portfolio, we exchange potential upside for premium income. If a share price rises above the option strike or exercise price at contract expiry (the contract term is usually a month), then the portfolio foregoes upside beyond this level [for more information on covered calls, read our Explainer].

For this strategy to work well, we therefore need to write call options at strike prices which are sufficiently high compared with the current share price – known as being ‘out-of-the-money’– so as to make the contract likely to expire unexercised. We can then keep the premium income and retain the underlying shares. The problem is that the higher the strike price and the more out of the money the option, the less premium income it generates.

Because this is such a tough balance to strike, we spend a lot of time analysing the premiums available across our portfolio, to identify those which we think are most attractively priced. We obtain quotes on all portfolio holdings across a range of strike prices from 5% to 20% out of the money. We then analyse this premium matrix to identify individual contracts which we feel are mispriced in our favour.

Unfortunately, over the last year or so, we have judged the conditions for call option overwriting to be unfavourable across the board. In a bull market with suppressed volatility, premiums were not enticing and it made little sense to forego potential upside.

Global quantitative easing flooded financial markets with liquidity, having a smothering effect on volatility and encouraging smooth asset price inflation.

Olly Russ - Using the return of volatility to boost income Euro Stoxx

Volatility matters because this is a key component of an option’s value to a buyer. From their perspective the option is worth more if volatility is higher as there is a greater chance of the share price fluctuating above the option strike price and generating a profit.

It was around this time last year that we highlighted the spooky absence of equity market volatility in the 2017 Halloween edition of Liontrust’s Ghoulish Gallery. This was a direct result of the global QE programmes introduced following the global financial crisis in 2008.

Twelve months later, it seems that we are at an inflection point. The ECB QE programme is due to end next month, leaving the Bank of Japan as the only major central bank still engaging in QE, while the US Federal Reserve is now reversing its efforts via quantitative tightening, running down its stock of bond assets with the effect of absorbing liquidity from markets rather than pumping it in.

Olly Russ - Using the return of volatility to boost income - Monthly Asset Purchases

Total global QE volumes have been in steady decline since late 2016, but it is only recently that this has fed through to resurgent market volatility.

Olly Russ - Using the return of volatility to boost income Euro Stoxx 2018

Having reached a 10 year low of under 11% in December 2017, European stock volatility recently rose over 23%. Unlike the bout of volatility experienced in February 2018 which rapidly subsided, we think it is here to stay this time.

Our analysis of premiums is showing the first signs of value for a year. We therefore reinitiated our covered call programme in October. This small selection of calls recently expired below their strike prices, generating some modest premium income for the portfolio in the process.

The rise in volatility accompanying recent market weakness has allowed us to write another batch of covered calls for November. The chances of a snapback rally in equity markets are of course fairly high, so we need to be cautious and select stocks with a favourable risk-reward for covered call writing. Nevertheless, the environment for this strategy is much improved. This month’s calls were written at a similar level to last month – about 10% out of the money – but the premium income generated for the portfolio almost doubled.

We think the lows in market volatility are well and truly behind us now that the artificial impact of QE is being removed. As a result, the covered call is back in the tool belt and ready to be deployed.

For a comprehensive list of common financial words and terms, see our glossary here.

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the European Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. Investment in the Liontrust European Enhanced Income Fund writes out of the money call options to generate additional income. These call options will be “covered”. Unitholders should note that potential capital growth of the Fund would be capped if these call options are exercised against the Fund and the Fund’s capital returns could therefore be lower than the market in periods of rapidly rising share prices.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.


Monday, November 5, 2018, 3:32 PM