Higher Yield and Lower Volatility
September 4, 2012
The additional income provided by selling these call options is an annualized 2.01%. The actual yield may be somewhat higher or lower, depending upon the prices at which we are able to replace those that expire mid-way through the year (see the expiration dates above). If I assume instead that we will not sell additional options later in the year, the additional income from the covered calls is slightly lower, at 1.8%.
When we combine the income generated by the portfolio holdings (6.98%) with the income provided by selling covered call options (2.01%), the total expected income for this portfolio is 8.99%. The projected risk for the UIP is equal to that of a portfolio that is 63% allocated to the S&P 500 and 37% allocated to the aggregate bond index (AGG).
Has the UIP performed as expected?
Let’s look at how well the UIP has done over the last two years, by comparing its actual returns and risk to what I predicted when I constructed those portfolios in 2011 and 2011. The table below summarizes the projected and realized performance of the UIP:
Summary statistics
The performance of the 2010 and 2011 portfolios reflects data for the 12 months following portfolio construction, reflecting the assumption that a new portfolio would be created each year to incorporate my latest research.
The n/a designations for the 2012 UIP are for data not yet available. The realized total return includes income generated directly by the portfolio holdings as well as option premiums from selling covered calls and price appreciation (if applicable) up to the strike price of the options. The realized total yield includes income generated directly by the portfolio (dividends, bond coupon payments, and distributions) as well as option premiums collected from selling covered calls.
The UIP strategy has performed consistently with expectations for each of its first two years. Today, yields on even the higher-yielding equities are fairly low and expected volatility, as measured by options prices on the S&P 500, is quite high. The track record of my UIPs illustrates exactly what I thought when I created them: Despite unprecedented, historically low interest rates, there remain compelling opportunities for substantial income at modest levels of risk – if you know how to identify them.
Appendix A: Projected volatility versus implied volatility
The chart below shows the projected volatility for each portfolio component in the 2012 UIP versus the implied volatility for the longest-dated listed put options. These results show how well the projected volatilities match the implied volatilities. The two outliers are CLMT and FTR. CLMT, in particular, is far off the relationship. Given this disagreement, I have made only a modest allocation to CLMT and FTR.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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