Covered Call Strategies

A covered call strategy involves holding a long position in an underlying equity index while simultaneously selling (writing) a call option on that same index. This strategy is often described as providing "equity-like" returns but with lower volatility. For example, an at-the-money (ATM) covered call on the S&P 500 index generally has a beta of approximately 0.5 to the underlying equity index, which contributes to its reduced volatility. While selling call options generates a volatility risk premium, replacing some of the lost equity risk premium from the reduced equity exposure, the strategy still adds risk compared to a pure 0.5-beta equity strategy. Globally, covered calls have delivered similar annualized geometric excess returns to their underlying indexes (5.4% vs. 4.5% average) but with significantly lower annualized volatility (14.8% vs. 21.2% average) and smaller maximum drawdowns (45% vs. 63% average).

A covered call strategy can be decomposed into three distinct economic components:
Passive Equity Exposure: This component represents the strategy's long-term average allocation to equity markets. It is less than 1.0 by construction and is responsible for earning the equity risk premium. It is the dominant source of risk for covered calls, contributing, on average, 70% of the strategy's variance.
Short Volatility Exposure: This component arises from the delta-neutralized short call option and captures the volatility risk premium. Equity index options tend to be richly priced (implied volatilities are higher than realized volatilities), making selling them a positive source of return for covered call strategies. It is the smallest contributor to covered call risk (7% of variance on average) but has the highest Sharpe ratio among the components (0.74 on average).
Dynamic Equity Exposure (or Equity Timing): This component reflects the changes in the covered call's equity exposure due to factors like the passage of time, changes in the underlying index's value, and implied volatility of the option. While it adds a relatively large amount of risk (23% of variance on average), its contribution to the strategy's expected returns is statistically insignificant across all indexes, implying it is largely uncompensated in efficient markets.

The volatility risk premium refers to the phenomenon where the implied volatility of options (the market's expectation of future volatility) is typically higher than the actual realized volatility of the underlying asset. This "rich pricing" of options means that selling them, as in a covered call strategy, can be a consistent positive source of return. This premium is not limited to the S&P 500 index; studies have shown its existence across various global equity indexes, contributing to the "short volatility exposure" component of covered calls and improving their risk-adjusted returns.

Dynamic equity exposure in a covered call strategy is a significant source of uncompensated risk. As the underlying index's value changes, for example, the call option's equity exposure also changes, which in turn dynamically affects the overall portfolio's equity exposure. This time-varying equity exposure adds risk but, in efficient markets, does not predictably contribute to expected returns. By actively hedging this dynamic equity exposure, investors can reduce the strategy's overall volatility without significantly impacting average returns, thereby leading to superior risk-adjusted returns (higher Sharpe ratios) and lower maximum drawdowns. For instance, hedging this exposure in S&P 500 covered calls reduced annualized volatility from 11.4% to 9.2%, increasing the Sharpe ratio from 0.37 to 0.52.

Risk-managed covered calls actively hedge the dynamic equity exposure to stabilize the strategy's equity allocation, typically targeting a constant beta (e.g., 0.5). This management technique results in:
- Higher Returns: On average, annualized excess returns improved from 5.3% for traditional covered calls to 5.9% for risk-managed ones (or 4.0% to 5.4% for compounded returns).
- Lower Volatility: Volatility was reduced by approximately 20% on average, from 14.7% to 11.7%.
- Improved Sharpe Ratios: The average Sharpe ratio increased from 0.35 to 0.51.
- Reduced Drawdowns: Maximum peak-to-trough drawdowns were lower in every index, improving from an average of -44% to -35%.
- Better Downside Characteristics: Risk-managed covered calls exhibited less negative skewness and lower downside betas.
When compared to underlying equity indexes, risk-managed covered calls provide similar returns with substantially lower volatility and smaller drawdowns, making them a compelling defensive alternative.

No, the benefits of risk-managed covered calls, particularly their higher Sharpe ratios, are estimated to remain intact even after accounting for transaction costs. While both traditional and risk-managed covered calls incur options trading costs (around 28 basis points per year for options, on average), risk-managed strategies also incur costs for hedging the underlying equity (estimated at 33 basis points per year, given high turnover). Despite these additional hedging costs, the net Sharpe ratio of risk-managed covered calls (0.46) still significantly outperforms that of non-risk-managed covered calls (0.33) and the average Sharpe ratio for equities (0.32).

Global diversification applies to covered calls for similar reasons it applies to equities. A globally diversified portfolio of covered calls provides exposure to multiple equity markets and short volatility premiums, while mitigating uncompensated equity timing exposure.
- Lower Volatility: Globally diversified covered call portfolios achieve similar arithmetic average returns as individual country strategies but with lower volatility. For risk-managed covered calls, average volatility for individual indexes was 11.7%, versus 9.7% for a market-cap weighted global portfolio.
- Higher Sharpe Ratios: The reduction in volatility from diversification leads to improved Sharpe ratios (e.g., a 0.06 improvement for risk-managed versions).
- Better Diversification of Components: The short volatility component, in particular, is more diversifiable across global indexes (average cross-correlation of 0.4) than the passive equity component (average cross-correlation of 0.7), further enhancing the benefits of global diversification for covered calls.
- Reduced Idiosyncratic Risk: Global diversification reduces concentration risk and exposure to single-country idiosyncratic events.

Equity index covered calls offer an attractive alternative to direct equity exposure by providing similar average compounded returns with lower volatility and reduced drawdowns. The research consistently demonstrates that managing the statistically insignificant but high-risk dynamic equity exposure embedded in options significantly enhances the Sharpe ratio of covered call strategies (an average improvement of 0.16). Furthermore, applying a global diversification approach to these risk-managed covered calls magnifies their benefits, leading to even lower volatility and higher Sharpe ratios compared to single-country implementations. Therefore, a globally diversified portfolio of risk-managed covered calls can serve as a superior, defensive alternative to global equity, offering similar returns with improved risk characteristics.