Covered Call Strategies: One Fact and Eight Myths

A covered call is a long position in a security and a short position in a call option on that security. Equity index covered calls are an attractive strategy to many investors because they have realized returns not much lower than those of the equity market but with much lower volatility. However, a number of myths about the strategy—from why it works to why an investor should or should not invest—have surfaced, and many of them are erroneously considered “common knowledge.” The authors review the underlying risk and returns of covered call strategies and dispel eight common myths about them.Equity index covered calls are an attractive strategy to many investors because they have realized returns not much lower than their underlying equity index but with much lower volatility. An equity index covered call owns the index and sells a call option on the index. These two positions expose the portfolio to two compensated risks and earn their respective premiums: the equity and volatility risk premiums.In order for the covered call’s risk and expected return profile to be understood, it must be analyzed from the perspective of its risk exposures. Because covered calls are rarely described in this manner, a number of myths about the strategy—from how it works to why an investor should or should not invest—have surfaced. Today, many of these myths are erroneously considered “common knowledge.” After reviewing the underlying risk and returns of covered call strategies, we dispel the following eight common myths about them:Risk exposure can be expressed in a payoff diagram.Covered calls provide downside protection.Covered calls generate income.Covered calls on high-volatility stocks and/or shorter-dated options provide higher yield.Time decay of written options works in your favor.Covered calls are appropriate if you have a neutral to moderately bullish view.Covered calls pay you for doing what you were going to do anyway.Covered calls allow you to buy a stock at a discounted price.In our view, the myths collectively conceal the simple facts that option overwriting is a version of selling volatility and that selling volatility is a risky strategy. If you believe that the underlying equity index will rise and that implied volatilities are rich, the covered call is a step in the right direction of expressing those views in order to capture expected compensation for the long equity and short volatility exposures embedded in covered call writing. History provides strong evidence in support of both risk premiums. However, if you have no view on implied volatility, there is no reason to sell options or invest in covered calls.