Covered Calls Uncovered

Typical covered call strategies collect the equity and volatility risk premiums but also embed exposure to a naive equity reversal strategy that is uncompensated. This article presents a novel risk and performance attribution methodology that deconstructs the strategy into these three exposures. Historically, the equity exposure contributed most of the risk and return. The short volatility exposure realized a Sharpe ratio of nearly 1.0 but contributed only 10% of the risk. The equity reversal exposure contributed approximately 25% of the risk but provided little return in exchange. The authors propose a risk-managed covered call strategy that eliminates the uncompensated equity reversal exposure. This modified covered call strategy has a superior Sharpe ratio, reduced volatility, and reduced downside equity beta.Equity index covered calls have historically provided attractive risk-adjusted returns, largely because they collect an equity risk premium and a volatility risk premium from their long equity exposure and short volatility exposure, respectively. However, they also embed exposure to an uncompensated risk, a naive equity market reversal strategy. In this article, the authors present a novel performance attribution methodology, which deconstructs the strategy into these three identified exposures, in order to measure each exposure’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%. The equity reversal exposure is responsible for about one-quarter of the covered call’s risk but provides little reward. Finally, the authors propose a risk-managed covered call strategy that hedges the equity reversal exposure in an attempt to eliminate this uncompensated risk. Their proposed strategy improves the covered call’s Sharpe ratio and reduces its volatility and downside equity beta.Editor’s note: Roni Israelov and Lars N. Nielsen manage option portfolios and covered calls at AQR Capital Management and may have a commercial interest in the topics discussed in this article. Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.Authors’ note: The views and opinions expressed herein are those of the authors and do not necessarily reflect the views of AQR Capital Management, LLC (“AQR”), its affiliates, or its employees, nor do they constitute an offer, a solicitation of an offer, or any advice or recommendation to purchase any securities or other financial instruments by AQR.