Covered Calls Uncovered

Abstract

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.