A covered call is an options strategy where an investor holds a long position in a stock and simultaneously sells a call option on the same stock. This strategy allows the investor to generate additional income from the premium received by selling the call option. The trade-off is that if the stock’s price rises significantly, the investor’s upside potential is capped at the strike price of the call option.
We have previously discussed the risk-adjusted returns of the covered call strategy in the US market. Reference [1] further studied the profitability of the covered call strategy in international markets. The authors pointed out,
The paper has evaluated the impact of call writing on the returns and risk of the ETFs. It is observed that the portfolio returns consisting of ETFs and Call writing has significant impact on returns and risk on the negative side. The returns were significantly lower and risk were significantly higher irrespective of which ETF is chosen in the portfolio. The only exceptions were portfolio consisting of OTM5 and OTM7. The portfolio consisting of OTM5 call options has increase of approximately 47% in Rupee terms and 27% in terms of percentage of investment, however the risk of the portfolio has almost doubled. The outcome shows the high volatility of option instrument, where it is common to lose a year’s gain in one week of negative return. Further ETFs though based on Index, do not reflect the Index’s movement perfectly and hence causing deviation in returns. The reason for higher return in case of OTM5 portfolios was the higher success rate of 68%. The higher success rate provides more positive outcome hence a better return if the strategy is applied for long term. The study shows that ETF portfolio with call writing can be an option if deep OTM is used for writing and the strategy is applied for long term.
In brief, in the Indian market, covered calls yield lower returns with higher risks (as measured by portfolio volatility). The exception is when selling far out-of-the-money call options, but even then, the risk-adjusted returns remain lower due to the higher volatility of returns. This result is consistent with the result in the US market.
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References
[1] Dr. Abhishek Shahu1, Dr. Himanshu Tiwari, Dr. Mahesh Joshi, Dr. Sanjay Kavishwar, An Analysis of the Effectiveness of Index ETFS and Index Derivatives in Covered Call Strategy, Journal of Informatics Education and Research, Vol 4 Issue 3 (2024)
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