Covered Calls Uncovered

Abstract

Equity index covered calls have historically provided attractive risk-adjusted returns largely because they collect equity and volatility risk premia from their long equity and short volatility exposures. However, they also embed exposure to an uncompensated risk, a naïve equity market reversal strategy. This paper presents a novel performance attribution methodology, which deconstructs the strategy into these three identified exposures, in order to measure each’s contribution to the covered call’s return. The covered call’s equity exposure is responsible for most of the strategy’s risk and return. The strategy’s short volatility exposure has had a realized Sharpe ratio close to 1.0, but its contribution to risk has been less than 10 percent. The equity reversal exposure is responsible for about one-quarter of the covered call’s risk, but provides little reward. Finally, we propose a risk-managed covered call strategy that hedges the equity reversal exposure in an attempt to eliminate this uncompensated risk. Our proposed strategy improved the covered call’s Sharpe ratio, and reduced its volatility and downside equity beta.

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