To write or not to write?

Derivatives can be very complex with the everyday investor having no real use for such dangerous and unknown tools. Yet, many retail investors do partake in covered call writing, the most simplified and straightforward investment strategy within derivative markets.

Should investors write covered calls on their investments?

The decision to write a covered call on stock an investor already owns depends completely on their outlook of the stock. Below outlines three perspectives an investor may feel regarding a stock;

1. Bullish:

Where an investor is bullish regarding their stock, they should not write a covered call. Their returns will be greater without the cap on the potential upside that a covered call has. In this case, the investor should simply play the stock (or even buy a call) to realise a higher return.

2. Neutral (slightly bullish or bearish):

In this case, an investor should write a covered call. This will allow the investor to capture the premium while not giving upside potential. Even a slight loss in the stock may still return a positive overall return due to the gain of the premium.

3. Bearish:

Where an investor is completely bearish regarding a stock, they should reconsider their entire investment and potential exit strategies. A covered call will deliver should downside protection, but the overall position will be a loser if the stock does drop dramatically.

What if an investor constantly wrote covered calls on the ASX200?

So, should the average investor write covered calls over their investments? Will it provide superior returns compared to stock returns? Well, the buy-write index (ASX:XBW) aims to compare the returns on the ASX200 given each stock has a written call (at the closest market price) over the stock.

Consider the graphs below. In Figure 1, during a heavy bull rally, the XBW index returned less than the ASX200, showing that if an investor is strongly bullish, they should not write covered calls. However, in the medium to long-term (Figures 2 and 3), where returns average out, XBW out paces the ASX200. Also note that XBW returns a more stable and consistent return with less volatility.

For long-term investors, with a diversified portfolio, they should strongly consider writing covered writes on their ASX listed investments for superior returns.