Covered Calls: Deep Dive Part 1

Includes: HSPX, PBP, PUTW
by: ADS Analytics


Covered Call or Buy Write is a popular income-generating investment strategy that boasts of lower drawdowns and better risk-adjusted returns than the underlying stock portfolio.

We investigate the strategy by analyzing the performance of the CBOE Buy Write and Put Write S&P 500 indices and indeed find attractive performance for some of the strategies.

We caution, however, that the Covered Call strategies can go through long periods of underperformance, and it is important for investors to understand the sources of its returns.

The Covered Call (alternatively called Buy Write) sector is somewhat unusual in the broader fund and, particularly, closed-end fund space. Unlike the bulk of the other sectors like High Yield, REITs or Mortgages, it is not simply an asset class but rather an investment strategy that combines multiple types of assets. More specifically, the funds in the sector have a long position in equities or equity indices and a short call position on usually the same holdings.

The sales pitch for the Covered Call sector has been that the investment strategy gives you immediate income, matched equity performance with lower drawdowns and better risk-adjusted returns. The Efficient Market Hypothesis suggests that this should not happen - that the reduction in risk should produce an equivalent reduction in returns. Another trouble with this claim is that covered call strategies are highly sensitive to the specific parameters such as option terms, strikes, rebalancing frequency and many other discretionary choices that can be made by the manager. This means that there are as many covered call strategies as there are funds. Unlike asset-based sectors, it is not possible for the manager to just load up on "covered call bonds" and head out to the links after lunch.

In this Part 1 of our deep dive into Covered Calls, we review the performance of a number of Covered Call benchmark indices and attempt to understand the drivers of their returns and, more importantly, the drivers of their out- or underperformance relative to the underlying stock index.

In Part 2, we will take a closer look at the actual fund vehicles available to investors, particularly ETFs and CEFs, and see what place these funds could have in a broader Income portfolio.

We present our detailed conclusions below - in short, over the long term we do not find evidence that the classic covered call strategies, as developed by the CBOE, outperform the underlying index after management fees. That is not to say that other non-classic covered call strategies cannot outperform the underlying consistently or that the standard strategies cannot outperform during periods of drawdowns or high volatility, or even that there are no reasonable investor utility functions that will find the long-term underperformance acceptable in light of improved risk-adjusted returns. Our main point is that the strategies need to be approached judiciously and each individual strategy evaluated on its own merits.

Motivating the Covered Call Strategy

The best way to motivate the discussion around the Covered Call strategy is to show how it compares to the underlying portfolio that it is designed to outperform.

The best data we have on this comes from CBOE, which has developed a number of option-based strategy indices based on the S&P 500. There are many more indices maintained by the CBOE, but the most relevant for our analysis are listed below. We include the PUT index along the Covered Call indices because Put-Call parity tells us an ATM Collateralized Put strategy should be pretty similar to an ATM Covered Call strategy.

CBOE Index

Investment Strategy

BXMD S&P 500 30-Delta Buy Write Index
PUT S&P 500 ATM Put Write Index
BXM S&P 500 ATM Buy Write Index
BXY S&P 500 2% OTM Buy Write Index

(Source: CBOE)

This is what the total returns look like:

(Source: ADS Analytics, CBOE)

What can we say about these results?

  • Two of the four indices outperform the S&P 500 over the entire time span.
  • The S&P 500 looks to have reduced its underperformance since about 2012.
  • PUT has by far the best Sharpe Ratio, even though its total return is next-to-last.
  • Oddly, BXM has massively underperformed PUT, even though Put-Call Parity tells us that the strategies are more or less equivalent.

So far, so good. Two of the strategies beat the index on a total return as well as Sharpe Ratio basis, and the third comes really close in total return to the S&P 500 and blows it away on a risk-adjusted basis - this is as good a sales pitch as there can be.

The outperformance of the CBOE indices looks to be monotonic to about 2012, but since then, the strategies have given up considerable ground. We need to investigate this further.

The fact that there is a big difference between PUT and BXM is indeed puzzling, as both sell near-ATM options - which, for those of us who were indoctrinated in Put-Call parity, appears to go against basic rules of physics. There are explanations for this having to do with a different "cash" component in the strategy as well as a slight difference in leverage, as well as the fact that BXM is effectively out of the market for a few hours one day a month. This is all well and good, but it does give a clear example how sensitive these strategies are to a seemingly trivial difference. The upshot of all this is that any fund taking BXM as its benchmark would have to solve this chronic underperformance for it to be a viable investment strategy.

Let's dig into the annual results to investigate the relative performance

Here we dig into the apparent drop in the outperformance of the indices relative to the S&P 500. In fact, we see that since the end of the financial crisis, the S&P 500 has bested the indices in 7 of the 9 years (marked with a red dot on the date axis), and often by a significant margin.

In fact, if we scan the relative performance for the entire time span, it does appear that the indices outperform the S&P 500 on drawdowns (e.g., 1990, 2000, 2001, 2002, 2008) and then give up this underperformance in subsequent years as the S&P 500 shows positive returns.

Our initial hypothesis is that when equities drop, volatility rises and the total premium collected by the investment strategy increases, which then allows the strategy to outperform the index.

(Source: ADS Analytics, CBOE)

And because volatility has been relatively subdued post the financial crisis, apart from the occasional spike, the strategies have tended to underperform.

(Source: ADS Analytics, CBOE)

Let's see if this hypothesis holds water. In the chart below, we pick the best-performing strategy - BXMD - and smash it together with the VIX to see if the performance of BXMD correlates to the VIX.

Indeed, it certainly looks like BXMD underperforms the S&P 500 (the green bar is negative) when the average VIX level for the year (blue bar) is relatively low.

(Source: ADS Analytics, CBOE)

Plotting the annual difference in returns as a scatter plot, we see an imperfect linear relationship emerge. The higher the VIX, the more BXMD tends to outperform the S&P 500.

(Source: ADS Analytics, CBOE)

We have to be careful, however, because there is no iron rule of markets that says that when volatility is high, selling options will outperform. We think the story is more complex and has to do with the richness of volatility priced into the markets. The fuller story we think is that when volatility is higher, the volatility premium (the difference between implied and realized volatility) is also high, and vice-versa. And when the volatility premium is high, selling options tends to outperform.

Why would the volatility premium be higher when volatility is higher? This could be because option sellers require a larger premium when the chance of loss is higher, or because the asymmetric skew profile of option selling worsens, or just simply because there are fewer option sellers when the market suffers a rout.

Our expectation is confirmed in the chart below - there does appear to be a positive relationship between volatility and the volatility premium:

(Source: ADS Analytics, CBOE)

Is it possible for volatility to rise but volatility premium to stay flat or even fall? We think yes for two reasons: luck and supply. First, the market could prove to be much more volatile than option traders think, and realized volatility could exceed implied volatility. Secondly, there could be systemic sellers of volatility that could depress the price options. This could be because of vehicles such as the now-defunct XIV, which rolled a large short VIX futures position as its investment strategy. However, now that some of these systemic funds were liquidated, there should be less of an overhang of volatility selling in the market. We don't think it is a coincidence that the Covered Call strategies has tended to chronically underperform in the same period that systemic volatility selling became a popular trade. Perhaps now that the decks are cleared, the Covered Call strategy will resume its outperformance.

Return Drivers of the Covered Call Strategy

To round out our analysis of the Covered Call investment strategy, let's review the return drivers of the strategy. For any investment strategy, it's worth understanding the sources of any positive expected return, as the return tends to come from certain risks undertaken by the investor.

  • Equity Risk Premium - Monetized through the capital gains of stock price appreciation to the call strike and the sale of further upside plus the dividends paid on the stock
  • Volatility Risk Premium - Monetizing the tendency of implied volatility to trade at a premium to actual realized volatility
  • Skewness premium - Earned for accepting nearly unlimited exposure to losses

For example, to illustrate the Volatility Risk Premium, we plot the 1-Month S&P 500 implied volatility (proxied by the VIX) against the 1-Month realized volatility. The positive spread between the two suggests that option premia are higher than "they should be" given subsequent volatility of returns. This makes sense given the asymmetry of returns for option sellers - a lack of such a premia, like a lack of a premia in insurance markets, would not attract many sellers.

(Source: ADS Analytics, CBOE)


On the face of it, the Covered Call investment strategy is appealing. This has not been lost on the investors who have put many billions of dollars into investment vehicles that follow this strategy.

We do think, however, that investors need to keep the following points in mind as lessons learned from our analysis.

First, details of the strategy are important. This is the lesson we learned from the underperformance of BXM relative to the other strategies. An imperfect strategy that leaves money on the table will add up to a large cumulative compounded underperformance relative to the underlying index or portfolio.

Secondly, it is important to remember the mechanics of Covered Call outperformance. That involves: 1) a drop in equities, 2) a coincident rise in volatility, and 3) an associated rise in the volatility premium. If all of these things happen, then the strategy stands a good chance of outperformance.

Thirdly, the Covered Call strategy is not obviously an "all-weather" strategy. The last near-decade has seen the strategy underperform the underlying index due to low volatility and a low volatility premium. With volatility increasing due to late-cycle dynamics and now with a bulk of systemic volatility sellers out of the market, this all could be a boost to the strategy - but only time will tell. Our analysis suggests that a VIX level of around 20 allows the strategy to outperform the S&P 500. This is a fairly high bar.

Fourthly, fees matter. The best-performing CBOE strategy only outperforms the S&P 500 by 0.4%, while management fees for Covered Call funds can run in excess of 2.5x that level, which means that unless investors approach the allocation to Covered Calls tactically, they may be best off investing in a cheap tracker fund.

Our final comment is to warn investors about the inherent bias in the common trade-off of accepting lower long-terms returns in exchange for ongoing income. The Covered Call strategy does exactly this by monetizing three risk premia into immediate income. To our knowledge, there are no ETFs or CEFs tracking BXMD, the best performing of CBOE indices. The second-best strategy, BXY, only has one ETF or CEF tracking it, and it underperforms BXY by 75bps - a figure close to its management fee. Unfortunately, the fund has only been trading during the post-GFC low volatility period, and so, has underperformed the S&P 500 by about 4.3% annualized since inception.

Please stay tuned for our Part 2, where we dive into Covered Call closed-end funds.

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Disclaimer: This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor. Although information in this document has been obtained from sources believed to be reliable, ADS ANALYTICS LLC does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. ADS ANALYTICS LLC does not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.