Expected Return and Risk of Covered Call Strategies

Abstract

This article provides a theoretical framework for analyzing a covered-call stock index strategy relative to the underlying stock index itself. The framework proposed allows for the decomposition and explanation of the strong historical performance of covered call strategies, which has been documented in several other articles. Formulas for the expected return and risk (semi-standard deviation) of the covered call strategy are derived and empirical comparisons to the underlying stock index are provided. The author defines a new concept, the call risk premium, which is the difference between a call's real world expected value and its price. A key insight of this article is that investors considering a covered call strategy must consider the positive effect of the implied-realized volatility spread versus the negative effect of the equity risk premium. A second insight is that, as the time to call option expiration decreases, the volatility spread effect significantly strengthens and the equity risk premium effect slightly weakens. Hence, it is usually better to implement the covered call strategy with short-dated call options. This finding is consistent with the intuition of most practitioners.