Covered Calls and Their Unintended Reversal Bet

Topics - Equities Market Risk and Efficiency Volatility Derivatives

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Covered Calls and Their Unintended Reversal Bet

AQR White Paper

Equity index covered calls have historically realized returns not much less than their underlying index with significantly less volatility. They have realized this performance by providing an exposure to the volatility risk premium in addition to the equity risk premium.

However, another important characteristic of covered calls is nearly universally ignored. Covered calls have a remnant exposure to equity market timing, an artifact of selling options. While portfolio managers typically focus on a covered call’s exposure to volatility, equity timing may contribute more than three times the risk of short volatility and nearly half the risk of its passive equity exposure. In fact, over a quarter of a covered call’s risk may be attributed to equity timing. More than likely an unintended risk exposure, equity timing is a significant component of a covered call’s return. This paper seeks to further our understanding of covered call strategies by shining a light on covered calls’ embedded timing of the equity market.

It is important that investors and portfolio managers understand the risks they are taking when owning a covered call. By exposing these risks, we invite investors to assess the appropriate course of action for their portfolios. We believe the portfolio can and should be hedged against exposures to market timing so that the limited risk budget may be allocated to compensated risk premia.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.