by Rosalyn Retkwa

Writing covered call options against a portfolio of stocks to get extra income and hedge against downside risk isn’t new — not to individual investors, who’ve been doing it for decades.

But to pension fund managers, “historically, covered call writing programs have always been considered a marginal strategy,” says Neil Rue, a managing director at Pension Consulting Alliance of Portland, Oregon. Over the last 18 months or so, in a volatile stock market, covered call writing programs have done pretty well, he says, so there is a new wave of interest from pension funds for the first time in a long time.

In the traditional form of covered call writing — done more by retail investors — options are written on individual stocks, and the risk is that if the stock rises beyond the option’s strike price, the stock can be called away or claimed by the option holder at a price that has become a bargain. In giving up the stock, the call writer sacrifices some of the stock’s gains but also gets the option premium as an offset. If the option is not exercised, the option writer pockets the premium as profit.

Today, on the institutional level, buy-write programs — where a money manager buys a basket of stocks and simultaneously writes corresponding call options — are more likely to use a single option based on a broad market index such as the BXM, the Chicago Board Options Exchange’s S&P 500 BuyWrite index. The index-based options are different because they are settled in cash and not by the transfer of shares.

“The last time covered call writing programs got a decent amount of attention [from pension funds] was after the relatively poor stock market performance of the early 1990s,” Rue says. But during the raging bull market of the mid- to late 1990s, writing covered calls became a losing bet. Rather than adding a little extra income to stock portfolios, covered calls nicked the gains. “People got upset because they were underperforming, so they bailed, right at the wrong time,” before the downturn of 2000 to 2002, he says.

The rub is that “these strategies truncate, or limit, the upside” on stock portfolios, and previously, pension fund managers “simply had no appetite for that,” says Greg Nordquist, senior portfolio manager and director of overlay strategies at Russell Investments in Seattle.

He says he has also been seeing “significant renewed interest in covered call writing over the last two years.” Before that, pension fund managers wanted to go for stock portfolio gains that were “as high as they could get,” he says, but now, they are “very willing to sacrifice some upside for that downside cushion” because they are heavily invested in equities, and cannot bear the extreme downside. He says that’s the answer to the question: “Why now?” and not sooner, since “these strategies have been around forever.” Continue reading →