Tales of a Technician: How to Build a Better Mouse Trap
March 13, 2016
Last update: July 2021
The tinker temptation is often undeniable for traders. It’s an itch to squeeze just a wee bit more alpha out of your strategy that just never goes away. No matter your trading approach the question of, “how can I make it better?” is always circling that big old brain of yours.
The ultimate objective is to craft a set of rules, a master plan, which effectively maximizes gains while minimizing losses in both turbulent and calm seas. Even those who have long since optimized their strategy still feel the tinkering itch beckoning.
Side Note: Alternate titles for today’s article are “Behold, Covered Call Perfection” and “The Quest for Covered Call Perfection.” I just couldn’t pass up the picture of the cute little mouse seconds away from getting whacked. Don’t worry though. All mice go to heaven.
Covered calls have commanded my attention off and on over the past few months (see here, here, here, and here) and I’ve discovered a few tricks to improve the returns delivered by the income generator.
And what better way to test my comprehension, not to mention signal to Karma that I’m a good little soul willing to share my findings with the masses than to divulge the details in all their glory to you?
Remember, the covered call (aka buy-write, covered write, synthetic short put) consists of buying 100 shares of stock and selling a call option to score both income and downside protection. If you own an ETF like the SPY and are selling monthly covered calls then the only question you really obsess over is strike price selection. Selling lower strike calls affords more income, more protection, but less potential profit (you quickly cut off your upside in the stock). Selling higher strike calls, say, 2% OTM, affords less income, less protection, but more potential profit since you can participate in more upside in the stock before having to part with your shares.
Most traders selling calls on a monthly basis will choose which approach appeals to them at the outset and then continue to sell the same strike price month after month. It’s systematic, consistent, and delivers the goodies as promised.
For example, in my intro trade lab we purchased the Nasdaq-100 ETF (QQQ) last April and have been selling slightly OTM calls every month. And, as promised, the covered call has indeed delivered superior risk-adjusted returns. We’re up 3.8% while those who have simply bought and held QQQ are down 3.5%.
That right there is what the highfalutin traders like to call 730 basis points of outperformance. Alpha achieved!
But what if adopting a more adaptive approach could yield better results? What if instead of selling the same strike every month, we modified the threshold depending on our directional bias? When more bullish we could sell 2% OTM calls, when neutral to bearish sell ATM calls.
The data for buying the S&P 500 and selling monthly ATM calls versus selling 2% OTM calls is already available. I referenced the CBOE S&P 500 BuyWrite Index (BXM) in my initial newsletter heralding the merits of the covered call (see here). Remember, BXM sells the first call with a strike above the current SPX price level. It’s basically the ATM option. Here is the performance of BXM (gray) over the past five years versus straight buying SPX (yellow):
Due to the multi-year bull market carrying stocks to the moon BXM has underperformed buy and hold by a wide margin. Such is the fate awaiting all covered call sellers during a running of the bulls.
Or is it?
What if we had sold OTM calls instead? For that, I introduce you to the CBOE S&P 500 2% OTM BuyWrite Index (BXY). As the name suggests it systematically sells calls 2% OTM monthly. And, as mentioned previously, writing OTM covered calls provides less income and protection, but more participation in the upside during bull markets. So, for example, with SPY perched at $191, we would sell the 194 strike call (191 x 1.02). That allows us to score $3 on the stock before the upside is capped. Here’s the performance of BXY (gray) versus long SPX (yellow):
BXY did a much better job keeping pace. And since the SPX tends to climb over time a side-by-side comparison of BXY vs. BXM reveals the superiority of selling 2% OTM calls.
Some may say the takeaway then is for traders to always take the BXY route. But see, I want a better mousetrap. And selling ATM calls is superior in neutral to bearish markets. That’s when BXM shines.
So here’s the idea. Adopt an adaptive approach in your covered call selling routine by shorting OTM options when bullish but ATM when neutral to bearish. You don’t have to stick with 2% OTM though. You might consider a 30 delta or some other metric in trying to select the optimal strike when venturing OTM.
The trick is knowing when to switch. Might there be an easy line in the sand we can use to dictate whether we’re in bull or bear mode?
Of course.
How about a moving average? We’ll want to use a longer-term measurement to minimize whipsaw and jive with the long-term time frame that’s consistent with selling covered calls month after month. The 200-day moving average comes to mind. When the SPY is perched above that we’re probably in a long-term uptrend suggesting selling an OTM call is the better route. When SPY falls below the 200-day moving average we could shift tactics and sell the ATM call.
Assuming we don’t get whipsawed too much the BXM/BXY combo should deliver better risk-adjusted returns than one or the other in isolation. Indeed the wisdom of the strategy is borne out by the efficacy of the 200-day moving average as our indicator over the past decade.
In the first graphic, we have the four episodes experienced over the 2009-2015 bull market where the SPY slipped below the 200-day moving average (red boxes). In these instances, we would have shifted to selling ATM-covered calls. Once the SPY remounted the 200 MA we would have reverted back to selling OTM. The lion’s share of the time we would have been following the BXY path with OTM options thereby participating in the bulk of the bull market.
But what about bear markets? Might there be too much whipsaw to justify switching tactics from short OTM to short ATM calls?
Nope. At least not during the past two bear markets.
Matter of fact it was smooth sailing during the 2008 meltdown as well as the 2001-2003 bear (shown below). The SPY remained below the 200-day moving average the entire time giving you a clear signal to continue selling ATM calls thereby scoring extra income.
With the SPY now soundly below its 200-day moving averages proponents of this tactical approach would look to sell ATM calls for the time being.
Of course, past performance is not indicative of future blah blah blah. Maybe the current bear market will be whipsaw city, rapidly ratcheting above and falling below the 200-day like a jittery drug addict in need of a fix. But, whatever, I mean eventually the SPY will make up its mind and start trending one way or the other. And at that point focusing on selling 2% OTM calls (in the case of an upside resolution) or ATM calls (downside resolution) will generate better returns.
If nothing else having a methodology for optimal strike price selection will keep you entertained. Selling covered calls is semi-boring. Granted it’s less boring than buy and hold, but boring nonetheless. Admittedly, good investing is supposed to be boring so maybe that’s a good thing.
But, hey, if you want to spice things up a bit and give yourself something to do. Switching up strikes based on market conditions may be just the ticket. Even though I used SPY in today’s examples, the QQQ, IWM or any other major index ETF would probably have generated similar outcomes.
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I really like your better mouse trap – hopefully we’ll have plenty of time to test it out when the bulls run up consistently, soon.
Tyler – Great article on the cov call strike selection strategy! I am also curious about how to determine the best time to expiration for cov call strikes given weeklies are available on most ETFs. Is there a set of rules or wisdom you can impart when it comes to choosing the right time to expiration for cov calls?
Tyler, I’m your fan.
I got a rookie question: Can I use this 200-day MA technique in any of the stocks I’m currently playing covered calls on?
Hi Christian,
You can. Just keep in mind some stocks behave better around the 200 MA than others. If the stock is hopping above and below the 200 MA like a jackrabbit then you’ll get whipped a little bit until a trend finally materializes.
Excellent article Tyler. Would it also be good to use the SPY 20 year seasonal averages for panning monthly bullish or neutral to bearish cycles and switch back and forth that way as well?