Covered call: Is it a conservative winning strategy?

This dissertation examines the performance of the fully covered call strategy both theoretically and empirically. In the first essay, using standard Black-Scholes assumptions, we show that the expected return and standard deviation of the covered call strategy are smaller than those of the underlying equity, either in instantaneous case or over a finite time horizon. Next, we show theoretically that the covered call for a set of out of the money strike prices could outperform a buy and hold strategy if Sharpe ratio is used as the measure to rank and choose portfolios. This seemingly contradictory result to the finance theory comes from the inappropriate use of Sharpe ratio when the return is non-normally distributed. The covered call strategy does not dominate the buy and hold strategy any more when using alternative performance measure that accounts for the downside risk. A Monte Carlo study confirms these results. In the second essay, a few empirical tests are conducted. The first study uses simulated call prices and the results show that the out-of-the-money covered call strategy outperforms the buy and hold strategy in various market conditions between 1969 and 1999. This surprising result is further confirmed by another empirical analysis that uses actual option price data from 1998 to 2002. The implication is that the call option contracts might be overpriced in the market.