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Concentrated Stock
Quarterly Update

Q4 2022

Highlights

NCAM Amish Dalal_CSQuarterly
Amish Dalal, CFA
Senior Vice President
Portfolio Management

Market Exposure Model

During December, inflation and monetary policy continued to be the key macro factors driving asset markets. Investors got more relief on the inflation front. The Consumer Price Index (CPI) fell 0.1%, in line with the consensus forecast, bringing year-over-year CPI down to 6.5%. However, we continue to maintain our conservative position and bearish outlook. Our market exposure score has dropped to 35% from 43% last quarter.
 

Stock Scoring Model

In the fourth quarter of 2022, our stock selection models outperformed the large-cap universe by 4.1%. We reduced our energy exposure due to lofty valuations. Conversely, we increased our allocation to health care as it appears stocks within this sector are better insulated from short-term inflationary pressures than other sectors. Our position on consumer staples, however, remains negative as high inflation and dwindling savings are forcing more consumers to rely on credit.
 

Options Pricing Model

The Fed raised its projection of the peak fed funds rate for 2023 and asserted that the work to tackle stubbornly high inflation was far from over. The central bank’s target interest rate—4.50%—is at its highest level in 15 years, and the implied target rate—5.125%—is even higher. Elevated interest rates generally imply greater option premiums or more upside potential for covered call strategies. We explore this correlation in more detail below.
TriplePlayGraphic

What Effect do Higher Interest Rates Have on Options?

Assuming a very simplistic model and holding all other variables constant, higher interest rates may present attractive opportunities for options investment solutions. Covered call strategies, which entail selling call options against stock positions to generate premiums, generally produce greater yields since interest rates and option prices are directly related. Higher interest rates bring about increases in the risk-free rate, which generally leads to expected increases in stock market returns. 

Another way to look at this is that, for the same level of risk (as measured by delta1), covered calls permit better upside participation now than in years with lower rates. Upside participation is calculated as the percent difference in the option strike price and the stock price at the time the covered call is initiated. For example, a stock priced at $100 with a $110 option strike price would allow for 10% upside. 

The time series graph below shows the relationship between the Fed Funds target rate, the implied (or expected) target rate, and upside for MSFT call options2. As expectations for interest rate hikes began to grow, even before the FOMC began to raise rates, the upside limit on MSFT covered calls increased.

USIntRatesUpside-1

The important takeaway is that right now, clients can capture more of a stock’s potential price increase with the same risk tolerance.

In summary, the current economic setting can be very beneficial for option strategies. In the following section, we discuss why.

 

Notes:
1 One interpretation of delta is the probability that a given option will expire in-the-money
2 Upside data series was plotted using actual NorthCoast MSFT covered call option trades within the same delta range

Portfolio Insights: Why Higher Interest Rates Make Options Solutions More Attractive

Markets have priced in a near certainty of recession this year while stocks continue to experience bouts of volatility. One way of adding value to portfolios is through covered call writing. 

NorthCoast’s Covered Call strategy, as mentioned above, involves selling call options against concentrated stock positions. Currently, a MSFT covered call is estimated to produce almost 6.3% in annualized premium while still maintaining 13.9% of upside potential.

Graph

By way of comparison, a covered call with similar duration initiated one year prior would have yielded only 5.5% annualized premium with 11.4% upside. 

Table1

Another way of looking at this is that, keeping the annualized premium constant at 5.5%, today’s market would impute 4% additional upside. 

Table2

On the other hand, keeping upside constant at 11.4% would mean 2% additional annualized premium.

Table3

Overall, both yield and upside look more favorable for covered calls, and this is expected to remain until the Fed starts lowering rates.

Sources: NorthCoast Asset Management, Bloomberg
 

Interested in how Concentrated Stock Triple Play may help your portfolio?

Contact your NorthCoast advisor or email us at info@northcoastam.com