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Equities play an important role in an income focused portfolio, offering a steady payment stream from dividends in addition to potential for strong capital growth over the long run.

For investors seeking higher income from their equity exposure a covered call strategy may be the answer. With the potential to generate a steady source of additional income, the strategy can significantly enhance the overall income for investors. A covered call strategy achieves this by selling call options on the equity in the portfolio, generating a cash payment (known as the option premium) which is exchanged for the potential equity upside above the option strike price at expiration.

This ‘classic’ covered call strategy adds a defensive profile to the equity investment, because the net return from the call options (i.e., the option premia minus any payouts of equity upside above the strike prices) is typically positive in negative or flat markets and negative in strong markets. In other words, a covered call strategy adds a defensive tilt to the market exposure. The strategy also aims to take advantage of persistent anomalies in option pricing (implied vs. realised volatility) to generate additional returns. While the defensive nature of this ‘classic’ options strategy maintains its utility for more conservative investors, the strategy is not best suited to strong recoveries or rallies in equity markets.

Our exposure-managed call overwriting strategy breaks the link between strategy returns and market direction. A dynamically-managed long index futures overlay aims to redistribute returns more evenly and substantially improve upside market capture. This isn’t a free lunch, however, as the strategy isn’t expected to cushion losses in down markets.

This approach offers investors an alternative to classic covered call strategies, with high levels of exposure in rising markets while retaining the benefits of income generation and potential returns from option mis-pricing.

Figure 1: Classic vs. exposure managed covered calls

A classic equity covered call strategy is constructed by combining a long equity position with a short call option position.

For example, an investor could combine a long position in the Euro Stoxx 50 index with a short call option on the same index struck ‘out of the money’ (i.e., an option strike price above the prevailing index level). The investor will receive a payment, the call option premium, intended to compensate them for the likelihood of the option ending up in the money. If the index level is below the strike price at expiry, then the investor will not make a payout. However, if the index level is above the strike then the option will expire ‘in the money’, and the investor will pay the difference between the final index level and the strike price. In effect, uncertain equity upside has been exchanged for a certain upfront cash flow.

Implementing this strategy systematically, rolling positions on expiration to provide consistent exposure, will influence the distribution of returns. The strategy boosts returns in flat or negative markets but reduces returns in sharply rising markets. As a result, the strategy exhibits lower volatility than the corresponding long equity position. Figure 2 illustrates the impact on the pay-off profile.

Figure 2: Illustration of a typical covered call return pay-off versus the corresponding long only equity position

The classic covered call strategy typically reduces returns in positive markets but increases returns in flat to negative markets.

source: ÃÛ¶¹ÊÓƵ Asset Management. Past performance is not indicative of future results.

Our exposure managed covered call strategy is designed to counteract the defensive bias in classic covered call strategies, reducing the impact of market direction. This is done by combining a covered call on an equity index with a dynamic long futures position in the same index.

At any point in time, we can calculate the sensitivity of the call option price to changes in the underlying index level, a measure known as the option delta. For example, if we have sold an index call option with a delta of 25%, say, then it is equivalent to a short equity exposure of 25%. We offset this negative exposure with a long futures position having long exposure of approximately 25% to broadly neutralize market directional exposure.

Note, however, that delta is not constant and changes as the market moves (and to a lesser extent, as other factors evolve), as illustrated in Figure 3. The net market exposure of a short call option will decrease as the market rises (down to a minimum of -100%) and rise as the market falls (up to a maximum of zero), as shown in Figure 3. We account for this within our futures overlay by adjusting the futures position when the delta moves significantly to provide an effective offset to the option exposure.

Figure 3: Illustration of short call option delta for an instantaneous market moves

As equity markets rise (fall) the market exposure of a short call option will become more (less) negative approaching negative 100% (0%)

As set out previously, our exposure managed covered call strategy aims to dynamically offset the market directional bias of short call options.

Market exposure is one of the key performance drivers for covered call strategies, but it isn’t the only one: the level of expected equity volatility reflected in option pricing also drives returns.

Historically, the expected volatility reflected in equity option prices (known as the ‘implied volatility’) has been persistently higher than the subsequent actual volatility (see Figure 4). This implied volatility premium can be thought of as compensation for option sellers for the uncertainty and asymmetry of potential payouts. Covered call strategies seek to benefit from this premium over time. For exposure managed covered calls this is the key driver of performance and provides the potential for positive net returns over time.

Figure 4: VSTOXX Euro Stoxx 50 implied volatility Index minus subsequent Euro Stoxx 50 one month realized volatility

The VSTOXX is an implied volatility index calculated from short dated exchange traded Eurostoxx 50 index option prices. On average the implied volatility priced into the listed options market has historically been higher than subsequent realized volatility of the index.

Source: ÃÛ¶¹ÊÓƵ Asset Management. As of 30 December 2022. Simulated data for illustrative purposes only.

The simulated performance of a covered call strategy on the Euro Stoxx50 index, both with and without futures exposure management, is illustrated in Figures 5a and b. The charts show the monthly net returns of the strategy plotted against the monthly equity market returns. In both cases, the returns are generally positive, as the strategies benefited from the implied volatility premium present over the simulated period, but it is clear that the exposure managed covered call strategy has removed the defensive bias and has a much more neutral market exposure.

Historical performance of our simulated strategy on the Euro Stoxx 50 Index compared to both the index and a classic covered call strategy may be seen in Figure 6a and b below. We construct our strategy using a diversified portfolio of short-dated short call options with a fixed premium target. Options are rolled on expiration and net market exposure is managed via a dynamic futures position.

Figure 6a: Performance statistics of the Euro Stoxx 50 index vs. the Euro Stoxx 50 index combined with a traditional and an exposure managed covered call strategy, 31 December 2012 to 31 December 2022

Figure 6b: Performance chart of the Euro Stoxx 50 index vs. the Euro Stoxx 50 index combined with a traditional and an exposure managed covered call strategy, 31 December 2012 to 31 December 2022

Developing and managing an exposure managed covered call strategy requires thoughtful design and careful implementation. We employ a systematic, research-based approach which specifically addresses the challenges of option strategies and ensures a consistent and robust outcome.

Options strategies are particularly exposed to the risks that the expiry time or strike level happen to be unfavorable. We mitigate these risks by staggering option trades across multiple start and expiry dates which results in diversified expiry times and strike levels. We also set strike prices dynamically, adjusting the strikes up and down to target stable yields as market conditions change. More generally, we invest in ongoing research to evolve and adapt the strategy through time and ensure that it remains efficiently constructed and implemented as market dynamics change.

Within the systematic framework, the strategy benefits from the oversight of an expert portfolio management team who actively consider option pricing parameters and market conditions and have the flexibility to adjust and adapt the strategy, particularly in periods of market dislocation. For example, by pausing implementation when markets are extremely illiquid, a pragmatic, discretionary implementation approach can add significant value.

Our exposure managed covered call strategy expands the range of strategies available to equity investors seeking high income.

The strategy provides an attractive and stable income stream with the potential for additional net returns by exploiting persistent biases in equity option pricing. Furthermore, the strategy removes the defensive bias of classic covered call strategies, allowing greater upside potential in positive markets.

Individual investors in enhanced equity income strategies may prefer the more defensive exposure from a classic covered call approach or the more growth-oriented exposure managed covered call strategy, but we believe that there is room for both approaches and the increased choice and flexibility will ultimately benefit investors.