Improving Portfolio Risk/Reward with Covered Call
by Robert Hahn, CFA, on June 13, 2023
In 1952 Harry Markowitz formulated Modern Portfolio Theory (MPT). Key tenants of this theory include:
- The merits of individual assets should not be viewed in isolation. Instead, assets should be viewed as to how each changes the risk/reward profile of the portfolio with the inclusion of that asset in the portfolio.
- Forecasting future investment returns is difficult at best. Historical returns of various assets are used to approximate as to how they might perform in the long-term.
The efficient frontier is a graphical representation displaying the risk/reward profile of various mixes of two assets, with the X-axis representing risk as measured by standard deviation and the Y-Axis representing return. The resultant graph shows a curve of all the possible portfolio allocations of Asset A combined with Asset B, going from 0% Asset A and 100% Asset B to 100% Asset A and 0% Assets B. The optimal portfolio mix maximizes return for a given level of risk.
Covered Call writing is utilized as an income generation and volatility reduction tool. Option premiums collected from selling calls are received upfront and, therefore, can dampen volatility in exchange for forgoing some potential upside in the underlying stock. The benefit of covered call writing can be displayed using the Efficient Frontier framework by combining a portfolio of the market as represented by the S&P 500® Index with the Connors Covered Call Strategy (“CCS”)1
The chart below graphically depicts the efficient frontier curve showing the various mixes of the Connors Covered Call Strategy representative portfolio with the S&P 500® Index for the five year period ending March 31, 2023.
The graph shows that adding the covered call portfolio to a market portfolio can enhance the risk/reward profile versus a market portfolio alone. Notably, even a 25% allocation to a covered call strategy can reduce the volatility of the total portfolio (S&P 500® Index) versus a market portfolio while still participating in much of the potential market return.
1The Connors Covered Call Strategy (CCS) is implemented in the Connors Covered Fund – a collective investment trust (CIT) [Connors Covered Call Fund] Alta Trust is a South Dakota chartered trust company that acts as the trustee of this Collective Investment Trust (CIT). CITs are bank maintained and not registered with the Securities and Exchange Commission. The Declaration of Trust for the CIT describes the procedures for admission to and withdrawal from the CIT. The Declaration of Trust and the CIT’s Employee Benefit Summary should be read in conjunction with this fact sheet and is hereby incorporated by reference. A copy of these documents may be obtained by contacting Alta Trust at email@example.com. Before investing in any collective investment trust, please consider the trust’s investment objective, strategies, risks, and expenses. Be sure to consult with your financial, legal, and professional tax advisors prior to investment in any collective investment trust. Performance is expressed in USD. Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. All investments involve risk, including potential loss of principal. There is no guarantee that the CIT will achieve its objective. CIT Restriction/Limitations: This CIT may only accept assets of defined contribution plans that are part of a pension, profit sharing, stock bonus or other employee benefit plan of an employer for the exclusive benefit of employees or their beneficiaries and is (i) exempt from federal income taxes under Section 501 (a) of the code, by reason of qualifying under Section 401(a) or 414(d) of the code or (ii) is part of an eligible deferred compensation plan maintained by a state or local governmental unit under Section 457(b) of the Code (“Section 457 Plan”), which is either exempt from or not subject to income taxation. Not FDIC Insured | May Lose Value | No Bank Guarantee | For Financial Professionals and Plan Fiduciaries Only,
Hypothetical Blended Return results were calculated by blending the Connors Covered Call Fund (CIF) monthly returns with the S&P 500® Index monthly returns using the weightings noted (100% CIF / 0% S&P, 90% CIF / 10% S&P, 75% CIF / 25% S&P, 50% CIF / 50% S&P, 25% CIF / 75% S&P, 10% CIF / 90% S&P, and 0% CIF / 100% S&P). Results presented do not reflect actual returns achieved by any Connors Investor’s clients. Standard deviation measures the variability of the monthly returns for each Hypothetical Blended Return series, calculated over the full time period presented (9/16/2016-3/31/2023). Hypothetical Blended Return results have inherent limitations, such as the results do not reflect the results of actual trading, but were achieved by means of retroactive application, which may have been designed with the benefit of hindsight. Another limitation is that performance may not reflect the impact that any material market or economic factors might have had on the decision-making process. For various reasons actual client experience and investment results vary and may be different from those portrayed.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Connors Investor Services, Inc. [“Connors”]), or any non-investment related content made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Connors. Connors is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Connors’ current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.