Inflation and Covered Call strategies

23 October 2021

Inflation has arrived, as expected. Despite its well documented corrosive effects, it can be a net positive for a number of investment situations; including Covered Call strategies (relative to long-only ones), if well implemented (viz, stock picking and timing).

Today’s monthly Inflation level (circa +4%) lags that of its historical pattern: which has seen peaks over +12% (the last time during the late 1970/early 1980s), with intervening deflationary rates of about -4%. Yet, this swing, or volatility of 16%, has been absent for the last 40 years. The primary reason is the Federal Reserve’s (and other Central Banks’) policies which have stamped out the expected Deflation of the post-Millennial period. Looking forwards, the ‘free-market’ economy looks quite directed.

In such an inflationary period, a Covered Call strategy could provide an edge for Options investors. Consider these three factors.

• Value stocks tend to outperform Growth stocks. This pattern has proven true over the last 60 years. Yet, in the last 30 years, Growth stocks have dominated, coinciding with (very) low Inflation rates. Growth stocks have higher multiples, so with a rise in Inflation, discounts rates also increase, lowering values. Thus, if trends continue Value stock strategies, particularly Income-oriented ones, should see an increase.

• Higher levels of Inflation invariably lead to increased Volatility. This dynamic should see higher prices for Options.

• The general level of Options prices has been supressed; with Inflation bounded at 1-3% for the last 30 years. One has seen; with premiums in the 4-6% range. With increasing Options prices, one wants to be a seller, not a buyer of options. This Inflationary context could see premiums rise towards double digits in the foreseeable future.

For a well implemented Covered Call strategy, it is not inconceivable to imagine an 8-10% annualised return, with much reduced risk versus the S&P 500.

Conclusion

If Inflation is on the rise, then many asset classes will be negatively affected, as well as Fixed income and Growth stocks.

A Covered Call strategy, if well-executed, may be a sensible play for the near term.

*

Justin Jenk is a business professional who enjoys discovering and connecting dots.

justinjenk.com