Introduction

Following my recent article about the lack of consistency in the returns of passive investing, let me present a few features of our methodology:

• Selecting non-correlated assets and strategies. Equity ETFs tend to be highly positively correlated with each other, regardless of whether or not being geographically diversified. Correlation changes and so does your real risk when holding a basket of stocks

• Targeting high-probability strategies with smaller drawdowns and a narrow return distribution range

• Don't get fooled by the ideal compound effect. In reality it's a myth: no one is capable of not touching the principal (whether you're adding or taking funds out of your account, you're still leaving your portfolio to too much chance). We invest to live off our income streams, buy new properties.

• Continuously adding capital to your portfolio isn't realistic: enjoy life! As the "big Data man" of TastyTrade pointed out in one of the 'Skinny on options data science' episodes, volatility hurts passive investing.

(Source: TastyTrade)

Looking At A Simple, Yet Strategic Approach: 5% In-The-Money Covered Calls on Salesforce

Setting up the problem of passive investing

Passive investing isn't about achieving consistent returns. Let's be smarter for a second and take a closer look at 5% in-the-money covered calls on Salesforce. Is this approach exposed to luck/randomness?

As presented in previous articles, this strategy would have generated an average return of 11.0% with 3.9% standard deviation over the past decade utilizing 107 months worth of data (based on Salesforce, the performance of this strategy will vary from stock to stock). Let me highlight that the backtesting doesn't include dividends or management techniques. Sometimes it won't make sense to sell an in-the-money covered call when we don't get enough bang for our buck. Most importantly, in periods of high IV we tend to reach 80% of our maximum profit within 3-4 months (compared to the holding period of 12 months).

Compared to the mean return of 10.0% and 9.9% volatility in the forward 1-year returns for the MSCI USA ETF this strategy seems to be a no-brainer. Unload your ETFs and go selling in-the-money covered calls on Salesforce and other stocks, right? The return distribution range is also far narrower than that of the EUSA buy-and-hold performance.

(Source: Option Generator Research)

(Source: Option Generator Research)

Salesforce: Buy-and-hold performance

Salesforce's share price performance has handsomely beaten the MSCI USA ETF (EUSA) over the past decade, generating a yearly average return of 20.9% with 20.0% standard deviation. So while the reward has doubled, the same is true for the risk.

In the study that we've recently conducted, we focus on 9 consecutive years of a particular strategy but entered at various dates. In this case, we're going to examine the buy-and-hold performance on Salesforce excluding dividends. Before diving into some incredible statistics, I'd like to explain what the trade series represent (always on the first day of the month, or as close as possible).

• Trade series 1: buy-and-hold performance from June 2010 to June 2019.

• Trade series 2: buy-and-hold performance from July 2010 to July 2019.

• Trade series 3: buy-and-hold performance from August 2010 to August 2019.

• Trade series 4: buy-and-hold performance from September 2010 to September 2019.

• Trade series 5: buy-and-hold performance from October 2010 to October 2019.

• Trade series 6: buy-and-hold performance from November 2010 to November 2019.

• Trade series 7: buy-and-hold performance from December 2010 to December 2019.

• Trade series 8: buy-and-hold performance from January 2011 to January 2020.

• Trade series 9: buy-and-hold performance from February 2011 to February 2020.

• Trade series 10: buy-and-hold performance from March 2011 to March 2020.

• Trade series 11: buy-and-hold performance from April 2011 to April 2020.

• Trade series 12: buy-and-hold performance from May 2011 to May 2020.

As you can see from the graph below, the last two trade series take the coronavirus crash and subsequent (partial) rebound into account. We want to intentionally show our readers the effects of a drawdown on your returns, which is particularly interesting for investors near retirement. Deciding at which time you start withdrawing funds from your IRA, 401(k)... will lead to various outcomes that are subject to the stock market's volatility at that point in time, i.e., the coronavirus crash.

(Source: Option Generator Research)

Looking at the box plots below, it might be too volatile for most people to hold onto their shares for a longer period of time.

(Source: Option Generator Research)

While most investors dream of perfect compounding, the opposite is true with 3/6/12 months between two purchases. This is especially true when volatility starts to spike (e.g. coronavirus crash, Q4 2018 meltdown). The bottom total return would have been 300% after 9 years of investing, whereas the maximum return comes in at 620%!

(Source: Option Generator Research)

Moreover, there's no consistency in the difference between achieving the maximum and minimum return in any given year. Changes in the stock's volatility and steep corrections interfere with the final outcome.

(Source: Option Generator Research)

Assuming a 20% annualized return, you now need an annualized 32% to reach your initial goal if we take the lowest portfolio value at the end of year 9.

(Source: Option Generator Research)

Picking the worst, 25th, median and 75th percentile returns, the range of possible outcomes is enormous and displaying the compound effect makes it even worse.

(Source: Option Generator Research)

Now, I don't want to say that you're always going to pick the bottom returns but it shows the impact of poor market timing. Let's be honest: we don't know what future buy-and-hold returns are going to look like and that degree of uncertainty/randomness doesn't lead to consistently high risk-adjusted returns.

(Source: Option Generator Research)

Salesforce: 5% ITM Covered Call Writing

While there's no single one strategy that perfectly fits the bill in all circumstances, selling a 1-year 5% in-the-money covered call (or cash-secured put) is the most effective way to reduce risk compared to holding stock outright. That's because we instantaneously lower our break-even by more than 13% (up to 23% in high implied volatility environments).

As can be seen from the graph below, the returns are wrapped around 11% with the maximum drawdown standing at 7.9%.

(Source: Option Generator Research)

The box plots tell us that the difference between achieving the 25th and 75th percentile returns is not that large, meaning we can execute the strategy very mechanically. The backtesting system isn't worried about technical analysis (in reality, we do factor in chart technicals) or other circumstances. In our opinion, this leaves room for strategy improvements.

(Source: Option Generator Research)

As can be seen from the graph below, the bottom portfolio growth stands at 115%, whereas te maximum return amounts to 190%.

(Source: Option Generator Research)

The following graph depicts the difference between achieving the maximum and minimum return in any given year. Because of a difference in either implied volatility or Salesforce's starting share price, year 1 immediately resulted in a considerable gap but it remained consistent over the subsequent years. It demonstrates that in-the-money covered call returns are far from fickle.

(Source: Option Generator Research)

Most importantly, our returns cannot be explained through randomness.

(Source: Option Generator Research)

In essence, playing out the benefits from the compound effect is far easier with in-the-money covered calls than buying stock and hoping for a happy outcome. Even the worst returns would have translated into a net gain of 45%.

(Source: Option Generator Research)

Comparing buy-and-hold with 5%ITM CC

To conclude this article, let's compare the different scenarios for a buy-and-hold performance with that of ITM CC. Assuming we pick the 25th percentile returns, you'll end up making roughly the same amount of profits for both buy-and-hold investing and ITM CC. However, the in-the-money covered call strategy exhibits 1/3 of the buy-and-hold standard deviation. Most importantly, picking the worst annual outcomes results in a positive 4.3% annualized return for ITM CC; the buy-and-hold investor would have suffered a negative 4.9% annualized return...

As it's not unlikely that we see current elevated levels of volatility persist into the future with below-average returns, selling in-the-money covered calls is far more strategic than just buying an ETF.

Right now, the amount of capital in our wealth management portfolios dedicated to in-the-money covered calls enjoys an adjusted breakeven-point that's 20%-25% lower than current market value. Consequently, we're not forced to turn around our portfolios and panic about today's market environment.

That's because - as can be noticed from the graph below - we don't play the same game as a passive investor. A lower breakeven point and smaller net long delta automatically lead to more consistency, lower standard deviation and smaller positive correlation.

(Source: Option Generator Research)

Conclusion

Creating consistency in your returns automatically leads to better results. Don't leave your portfolio to too much chance, but invest strategically through a thorough understanding of correlation and thus true diversification. In-the-money covered-call writing has historically exhibited less standard deviation with the bulk of the returns wrapped around the average. Buy-and-hold investing, on the contrary, sees more outlier moves which can lead to better- or worse-than-expected returns if one tries to time the market. For most people, it's unrealistic to always stay 100% in the game as unexpected healthcare expenses start interfering with our final results.