Portfolio Insights: Creating Value through Active Management
NorthCoast’s strategy in managing covered calls is to utilize active oversight, a unique take on traditional options trading.
In last quarter’s article, we discussed the circumstances under which the NorthCoast team tactically executes options trades in a client’s account (see “What Happens to Covered Call Strategies in an Up Market and What Can We Do About It?”).
The core idea is to close options that have breached internal risk thresholds. One scenario is rolling2 out-of-the-money (OTM) options into new options to produce an additional stream of premiums, but in a risk-aware manner. Alternatively, we may take advantage of the increasing underlying stock price to roll in-the-money (ITM) options early and into higher strike prices. This is to better protect the underlying position from call-away risk and to secure higher upside potential. Timing is important. Waiting to roll OTM options could reduce total premiums collected (opportunity cost) and waiting until the option is too deep ITM may significantly increase the net cost to roll.
The below graph illustrates our covered call trades for a concentrated position in Tesla (TSLA). The period chosen shows how the option overlay was managed when TSLA was up, down, and sideways. The green and red dots specify when the options had drifted below or above the internal thresholds.
What happened? After TSLA’s lackluster start in 2021, we decided to roll the OTM $360 option prior to expiration to secure additional premiums. Afterwards, the stock hit all-time highs in the fourth quarter due to several consecutive quarterly earnings surprises along with speculation that the company would continue to attract market share and pioneer new technologies. Therefore, we opted to close the option and write new covered calls with a 58% higher strike price for more upside. During each subsequent roll over the next several months, we preferred to keep strike prices elevated to maintain a high level of upside.
But in the second half of 2022, our positive score on TSLA turned negative due to the stock’s rich valuation and relative value against its peer group. In response, and after accreting almost full value on the active option positions, we reduced the strike price on the roll to capture attractive option premiums. By the end of the year, TSLA shares retreated in sympathy with the tech sector. From its peak in November 2021 to its low point in January 2023, TSLA shares experienced a 73% drawdown.
In H1 2023, due to concerns over a prolonged bear market rally and upside volatility for TSLA, we ratcheted strike prices higher to better absorb interim shocks and avoid capping returns on the stock. But given our cautious outlook and slightly negative TSLA score, we believe the current level of strike prices is appropriate and expect covered calls to produce additive returns versus a stock-only portfolio.