Are covered calls the right option for Australian investors?

Abstract

Purpose: The purpose of this paper is to examine whether superior risk-adjusted returns can be generated using monthly covered call option strategies in large capitalized Australian equity portfolios and across varying market volatility conditions. Design/methodology/approach: The authors construct monthly in-the-money (ITM) and out-of-the-money (OTM) S&P/ASX 20 covered call portfolios from 2010 to 2015 and use standard and alternative performance measures. An assessment of variable levels of market volatility on risk-adjusted return performance is also carried out using the spread between implied and realized volatility indexes. Findings: The results of this paper show that covered call writing produces similar nominal returns at lower risk when compared against the standalone buy-and-hold portfolio. Both standard and alternative performance measures (with the exception of the upside potential ratio) demonstrate that covered call portfolios produce superior risk-adjusted returns, particularly when written deeper OTM. The 36-month rolling regressions also reveal that deeper OTM portfolios deliver greater risk-adjusted returns in the majority of the sub-periods investigated. This paper also establishes that volatility spread variation may be a driver of performance for covered call writing in Australia. Originality/value: The authors suggest that deeper OTM covered call strategies based on large capitalized portfolios create value for investors/fund managers in the Australian stock market and can be executed in volatile market conditions. Such strategies are particularly useful for those seeking market neutral asset allocation and less risk exposure in volatile market environments.