This video analyzes the performance of a covered call strategy on Tesla (TSLA) stock from 2018 to 2025. The speakers explore the mechanics of covered calls, the complexities beyond simple income generation, and the impact of volatility on profitability. They examine various indicators to optimize the strategy and compare covered call returns to a delta-hedged approach.
Citations for Question 1: "in this scenario in in our study uh we made the assumption that you were buying back the option um for a loss if uh it got you know if it went in the money Uh and the effect of that is that you maintain a constant balance of shares except for if stock splits as Tesla did twice But in theory you keep your same balance of shares and you're just accumulating generally short-term losses with that That would obviously require additional funds um you know if you spend all your money on the stock and the call you know those dynamics change um and that's why you know often investors will choose to let some of it get called away and you know perhaps reby in with smaller amounts uh down the line but we chose to treat this as pure losses from the option landing in the money"
Citations for Question 3: "if you had simply bought Tesla at the beginning of 2018 you're up 12.4x on your money Um you know the chart is parabolic uh with some draw downs some significant draw downs Um but the difference is if you had been overwriting throughout all that time you gave away so much of that upside And not only did you give that away because you were selling that 25 delta level as we'll explore a little bit more the path dependence in there means you're locking in losses at high levels and you know letting the stock drop down again That you know depending on your method like I was saying about letting shares get called away versus buying it in that could have an impact there too But at the end of the day overwriting and buying that in only doubles your money um over that period which wouldn't even do as well as the S&P 500 right so you're So in other words uh if you knew in advance that a stock was going to go up a,000% over the next six years it's probably a bad idea to overwrite calls on it"
Covered calls are not solely about income generation; they involve significant volatility risk: The video emphasizes that the premium received for selling a covered call isn't purely profit; a substantial portion compensates for taking on the risk of limited upside potential. The seller is essentially shorting the volatility of the underlying asset. This means that while you collect premium, your potential profit is capped at the strike price of the call option. If the stock price significantly surpasses this level, the potential gains are lost when the option is exercised.
Path dependency creates unpredictable outcomes in covered call strategies, especially with volatile assets: The success of a covered call strategy is highly dependent on the specific sequence of price movements (the "path"). In highly volatile stocks like Tesla, a series of upward price movements followed by a sharp decline can lead to substantial losses. The timing of price fluctuations matters more than the overall average price movement because the option's value diminishes as it approaches expiration. The strategy's success becomes heavily reliant on when the price reaches a certain point before the option expires.
Delta hedging provides insights into volatility's impact on P&L, illustrating market efficiency: By employing delta hedging, the strategy neutralizes the directional risk of the underlying stock, isolating the impact of volatility. The results show that even in a highly volatile environment, the market effectively prices volatility. Profit from delta hedging comes primarily from the decay in option value over time (theta) and the gains/losses associated with rebalancing to maintain the delta neutral position. Small gains were observed demonstrating that consistently exploiting mispricings in volatility is challenging, even with a volatile underlying.
Volatility indicators offer minor improvements, primarily by reducing trade frequency: Using volatility indicators as filters did not significantly improve returns overall. The most effective use of the indicators was to reduce the number of times the covered call strategy was executed. This suggests that the consistent application of a covered call strategy, regardless of market conditions, can be detrimental in highly volatile environments. Rather than identifying specific mispricings, the indicators acted as a filter to minimize losses during adverse market conditions.
Unexplained P&L highlights the limitations of basic Greek-based attribution models: A significant portion of the P&L in the delta-hedged approach remains unexplained, particularly during periods of significant price movements or nearing expiration. This is because simpler Greek-based models fail to capture the dynamic changes in option sensitivities during these times, which is why more sophisticated models might be required. The unexplained P&L stems from the limitations of using static Greek values to predict option price changes over periods with substantial volatility. This underscores the need for more nuanced models when analyzing options trading strategies in dynamic and uncertain environments.
The video doesn't provide a definitive "how-to" guide for flawlessly executing a covered call strategy, especially given its focus on highlighting the complexities and limitations, particularly with a volatile underlying like Tesla. However, based on the discussion, here's a summary of considerations for a more informed approach:
1. Understand the inherent volatility risk: Don't view covered calls solely as an income-generating strategy. Recognize that a significant portion of the premium compensates for the risk of limiting your potential upside. The higher the volatility, the greater the premium, but also the higher the risk of losing significant gains if the stock price skyrockets.
2. Consider path dependency: The sequence of price movements drastically impacts your outcome. Large price increases early in the option's life may lead to substantial losses later if the price drops. Avoid over-reliance on historical data and averages; focus on current market conditions and the specific path the stock is taking.
3. Carefully choose your expiration date and strike price: The selection is crucial. Shorter-term options generally offer lower premiums but less time for the stock price to move significantly. Longer-term options have higher premiums but also greater risk. Similarly, the strike price dictates your profit and loss points. Strikes too close to the current price dramatically limit your upside, while strikes too far out may offer minimal premium.
4. Use volatility indicators judiciously: The video suggests that using volatility indicators (like implied volatility, volatility risk premium, and skew) as filters to reduce trade frequency can offer some marginal improvement. However, these indicators aren't a guarantee of success and shouldn't be solely relied upon for timing your trades.
5. Understand the limitations of P&L attribution: Basic Greek-based attribution models can be insufficient, particularly in highly volatile situations. Large price swings and times close to expiration can produce significant unexplained P&L. This means simple models may not accurately reflect the actual gains/losses and should be used cautiously. Consider more advanced models which account for higher-order Greeks when analyzing returns.
6. Dynamically adjust your strategy: The video strongly suggests against a completely static, systematic approach. Be prepared to adjust your strategy based on market conditions and the specific circumstances surrounding the trade. A rigid, set-it-and-forget-it approach to covered calls can be detrimental.
7. Consider alternative strategies: If aiming to profit from a highly volatile stock, alternative strategies (e.g., selling puts instead of calls) might be more suitable depending on your risk tolerance and market outlook.
In essence: Successfully executing a covered call requires a deep understanding of options pricing, volatility, and risk management. It necessitates a more flexible and adaptable strategy than a simple, automated approach. The findings from the video caution against overly simplistic assumptions, particularly with highly volatile assets.
