Revisiting Covered Calls and Protective Puts: A Tale of Two Strategies

Abstract

This article examines the historical risk-adjusted returns of two hedging strategies designed to minimize downside market risk: protective puts and covered calls. Using US market data from 1993 to 2020, I find that covered-call strategies outperform the buy-and-hold strategy on a raw and risk-adjusted basis over the entire sample and that these excess returns appear to be consistent over time. After factoring in transaction/trading costs and income tax implications, the returns for the out-of-the-money call options maintain both significantly higher raw and risk-adjusted returns than the buy-and-hold strategy. I also find the opposite results hold for the protective put strategy: This strategy not only significantly underperforms the buy-and-hold strategy from a raw and risk-adjusted return standpoint but also actually significantly increases the probability of incurring losses each month. Finally, I evaluate the overall utility of various covered call strategies for loss averse investors, using the standard prospect theory utility function. Here, I find that out-of-the-money covered-call options yield the highest utilities for investors with less-than-average loss aversion, whereas in-the-money covered-call options become more favorable as loss aversion increases.