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[Kapadia & Szado, 2007] and reached similar conclusions.
All five key studies agreed that:
1. In falling markets, covered-call writing returns outperform
pure index portfolios.
2. In markets trading in a range, covered-call writing
also outperforms index portfolios.
3. In rising markets, covered-call-writing returns underperform
index portfolios.
These general findings could have been anticipated by
comparing a typical index covered-call gain or loss (P/L) at
call expiry, with the gain or loss on the underlying index. A
simplified hypothetical P/L profile for this purpose appears
in Figure 4, where two breakeven points are easily identified
for an at-the-money covered call. The lower breakeven at 95
occurs at a value equal to the strike price of 100 less the initial
call premium of 5, while an upper breakeven point at 105
occurs at the value equal to the strike price of 100 plus the
initial call premium of 5. These two breakeven points divide
the covered-call P/L outcomes into three regions of return:
Region 1: When the index level at call expiry is below the
lower breakeven, the investor experiences a realized loss on
the covered call but outperforms the index at all outcomes
in this region. This result corresponds to the first of the three
covered-call findings from the key studies cited above.
Region 2: When the index level at call expiry is
between the two breakeven points, the covered call also
outperforms the index at all levels, corresponding to the
second finding of the key studies.
Region 3: When the index level at call expiry is above the
upper breakeven, there is a realized gain on the covered
call but this gain is less than that on the index, corresponding
to the third finding of the key studies.
While each of these findings could have been anticipated
from inspection of Figure 4, many useful numerical results
from the key studies required careful detailed analysis.
Important among the additional findings was that coveredcall
returns were above that of the index for the period
1986 to 2011 and were achieved with a volatility about onethird
lower than that of the index alone. This same period
included rising, falling and range-bound markets. In rising
markets, covered-call writing underperformed the market.
Because returns are capped when calls become in-themoney,
correlations between index and strategy returns
drop. This latter finding suggests that covered-call writing
occupies a position on the capital market line that offers
returns in rising markets that are generally below that of
the index but above that of cash, much as graphically represented
in Figure 5. This position of covered-call writing on
the capital market line conveniently suggests that there is
also portfolio diversification potential in this strategy.
Covered-Call ETF Benefits And Concerns
Financial journalists often make three negative warning
observations about covered-call ETFs. The first warning is
that covered-call writing is a strategy that underperforms
the market, implying that the strategy should be avoided.
The warning is based on the mistaken assumption that
this strategy is designed to outperform the market at all
Figure 4
Maturity P/L
10
8
6
4
2
0
-2
-4
-6
-8
-10
Comparison Of Index And Covered-Call
Outcomes At Call Expiry
Maturity P/L For At The Money Covered Call Vs. Index
Strike Price At 100; Call Premium 5; No Costs Or Dividends
Realized
Loss
Lower Breakeven
Upper Breakeven
90 92 94 96 98 100 102 104 106 108 110
Index At Cal Maturity
Source: Author’s calculations
Figure 5
Return %
20
15
10
5
0
■ Cover-Call P/L
Index P/L
Representation Of Covered-Call Performance
In Rising Markets
Cash
0 2 4 6 8 10 12 14 16 18 20
Source: Author’s calculations
Covered-Call Writing
Volatility (%)
Index
times. As the key studies clearly demonstrate, covered-call
returns should be expected to underperform in rapidly
rising markets because capital gains are limited above the
call strike price. Conveniently overlooked by journalists is
that outperformance of covered-call ETFs can be expected
both in range-bound and declining markets.
A second mistake made by journalists is to compare
price-only returns from covered-call funds against total
market returns. Proper return comparisons between strategies
can be made only by including costs and dividends
received. Such inclusions sometimes reveal a favorable
comparison, as was the case from 1986 to 2011, when covered-call
writing in the U.S. market outperformed indexes.
A third erroneous claim found in the financial press is that
covered calls fail to provide a hedge against declining markets.
Professional covered-call writers know that sold options provide
two sources of partial protection against price declines.
For out-of-the-money calls, the premium received provides
a partial hedge by lowering the cost basis of the underlying
asset. For in-the-money calls, the option premium also
contains intrinsic value that provides an additional powerful
1-for-1 offset against asset price declines. Neither in- nor
out-of-the-money written calls can provide a complete hedge
against a declining market, nor are they designed to do so, as
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