The case for/against Covered Call trading strategy

October 28, 2019
October 28, 2019 admin

Preface

A covered call is considered a very common trading strategy for many options traders, It’s relatively simple and promises to improve the equity curve for any options trader who also has some equity in the portfolio, it’s perceived to be a passive investment vehicle, with low maintenance and low risk. It’s also usually the first options strategy a novice options trader implements because of its simplicity and low risk, so its a very common options strategy for many traders.

When going through research papers that backtested the strategy and got some insights of its results, you may find many of them that reach the conclusion that trying the simplistic version of a covered call does not produce the promised results, on the contrary, its a losing strategy in most cases, So who is right? Is it a losing strategy? this is exactly what I would like to find out in this blog article and the next,this is part one of a two-part article in which we research the strategy trying to improve its performance against a simple buy and hold.
Let’s dig in.

What is covered call?

A covered call is a strategy where you sell a call against an asset that you already have in your portfolio, hoping that the call you have sold will expire worthless providing you with extra cash in that case. If this is not the case and the call goes into the money the strategy has limited gains since you profit from the underlying going up but lose the same amount from the obligation in the option you have sold, more on that in this link.

Implementing the simplistic version of the strategy on S&P500

Let’s establish a base and try to implement the strategy on the S&P500, holding the SPY ETF for the entire backtesting duration which is 10 years 2009-2018, essentially implementing a buy and hold strategy, selling OTM calls with 30 days to expiration, this means we are trading with the following conditions:
Entry: Buy and hold SPY, plus, every first day of the month sell 1 out of the money(OTM) call for the next 30 days, OTM strikes are selected with delta lower than 20
Exit: on expiration(end of the month)

When trading this strategy, these are the results:
Alpha= -0.013
S&P500 Sharpe Ratio = 1.06
With CC Sharpe Ratio = 0.99
S&P500 CAGR=12.71%
With CC CAGR=11.86%

Lets explain the results we have observed:
Alpha is the excess return the strategy has over the buy and hold strategy, as we see the covered call strategy performance is slightly lower than the performance of the buy and hold.
The Sharpe ratio which measures return per unit of risk is also lower, and so is the annual return.
Analyzing the return shows that the classic approach does not work here ,not only do we not make money we have to maintain another strategy that ultimately has inferior performance.

What’s the reason?

Analyzing the results shows a number of reasons but the main reason is the major caveat of selling a call and that’s capping of the maximum profit in case the underlying moves strongly to the upside, in this case the underlying price goes into the money , sometimes far into the money, essentially wiping out that profit for the entire strategy since in that case you profit from the underlying moving up but lose the same amount from the call option the strategy holds, if there are many such strong moves to the upside, into the money, the strategy loses continuously rendering the entire effort useless.

So the approach has to change in order to protect the covered call strategy from strong moves of the underlying into the money.
One method we may try is to roll up and out, this way we avoid the assignment on expiration day and reducing the amount of time the strategy is in the money, so a minor adjustment to the strategy rules:
Entry: Buy and hold SPY, plus, every first day of the month sell 1 out of the money(OTM) call for the next 30 days, OTM strikes are selected with delta lower than 20
Exit: when the price reaches the strike or on expiration(end of the month)

Trying to use this approach yields tese results:
Alpha= 0.24
S&P500 Sharpe Ratio = 1.06
With CC Sharpe Ratio = 1.3
S&P500 CAGR=12.71%
With CC CAGR=14.87%

That’s better, rolling up and out certainly improved the performance metrics (Sharp ratio is up by 30%) and the strategy beats the S&P500 in the 10 years backtesting duration. This means that now the strategy is not a passive low maintenance trading strategy, now you have to maintain the status of the strategy, making sure that the price of the S&P500 does not go into the money, but truth be told that’s really not a lot of work.

In the next article, we will suggest ways to improve the method even further improving its performance metrics,

Trade safely,
Alon

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