Why Covered Call Writing Is No Free Lunch

 |  Includes: ETY
by: David Goldman

All the income funds that use a covered call strategy have underperformed the market woefully. The Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE:ETY) is one of the largest and best-managed, and its results are deplorable:

Chart forEaton Vance Tax-Managed Diversified Equity Income Fund (<a href='http://seekingalpha.com/symbol/ETY' title='Eaton Vance Tax-Managed Diversified Equity Income Fund'>ETY</a>)

There’s an obvious reason why this seemingly reasonable strategy is a snare and a delusion: portfolio gains are not normally distributed. Creative destruction leads to huge losses on a few stocks, and huge gains on others.

If you cap your upside by selling covered calls, you are likely to snip off the right-hand tail of the distribution — but most of your returns are in the tail. That’s one of the “Black Swan” problems: you make most of your returns on a surprisingly small number of trading sessions (and that’s why selling index calls doesn’t work, either).