Enhanced Covered Call Writing – AQR Paper

Covered calls are an extremely popular strategy utilized by large institutions and retirees alike. As chase for yield continues it will likely continue to be popular as it is sometimes viewed as an equity income trade or enhance income trade. Take a look at S&P index skew or call skew for most S&P underlying to see the downward pressure in pricing of calls versus puts due to flows.

AQR put out an interesting paper in May 2014 which I will attempt to summarize:

1) Covered Call writing performance actually comes from 3 variables, the equity risk premium (stock market), the volatility premium (IV), and a new premium they call the equity reversal premium. While the first 2 should be self explanatory, and any positive method of forecasting either premium should enhance returns, the 3rd one is quite interesting and unique.

The Equity Reversal Premium can be thought of as a market timing strategy. The equity exposure (or exposure to equity risk premium) is a function of the delta of the short call. An ITM covered call actually has little to no exposure to the equity risk premium while an OTM covered call has almost 100% exposure to the equity risk premium. This should make sense?

Source: AQR

Source: AQR

2) So the variance of the equity exposure is similar to a market timing strategy where you buy more index as it moves down and sell the index as it moves up. If market is choppy, this should do well, in a trending market….not so much.

3) The paper suggests hedging the equity reversal premium and maintaining exposure to just the Equity Risk and Volatility Risk Premiums. They suggest delta hedging the option in addition to the equity exposure and the results look impressive:

Source: AQR

Source: AQR

The next step would be back-testing this strategy. Finding delta data might be difficult, as well as adding in commission costs of added trading! I also do not know the hedging frequency and duration of the call sold initially but I might be able to boot strap something!

https://www.aqr.com/~/media/files/papers/aqr-covered-calls-and-their-unintended-reversal-bet.pdf

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~ by largecaptrader on March 4, 2015.

One Response to “Enhanced Covered Call Writing – AQR Paper”

  1. […] Enhanced Covered Call Writing – AQR Paper [Large Cap Trader] Covered calls are an extremely popular strategy utilized by large institutions and retirees alike. As chase for yield continues it will likely continue to be popular as it is sometimes viewed as an equity incom… […]

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