Covered Call Writing from an Expected Utility Perspective

Abstract

“Writing covered calls is one of the most popular investment strategies involving options. It is often recommended by investment analysts, not infrequently with extravagant claims about high expected returns and low risk. By contrast, among the firmly established principles of finance are that there is no free lunch, and that a strategy that reduces risk exposure (for example, by writing calls that partially offset the market exposure of a long position in the underlying) should lead to lower expected returns. Rendleman addresses the following question: what assumptions about expected return and option (mis)pricing are required in order for an investor with constant proportional risk aversion to prefer writing covered calls to simply holding the underlying, the riskless asset, or a long call? Moreover, is it better to write long- or short-dated contracts? The results indicate that unless calls are significantly overpriced, the strategy is much less attractive in general than its promoters assert.”