Performance of 1M Covered Call SPY Strategy

The covered call is the most basic of income strategies and is known for providing additional income as well as partially reducing drawdowns from owning the underlying stock. The basic concept is to own the stock, and sell an out of the money call option on a monthly basis as a means of collecting additional income. The risk being that if the stock rises above the call strike, you'll be exercised and you won't receive any additional gain above the strike.

To take a closer look at the historical performance of a 1 Month covered call strategy on S&P 500 ETF SPY, I loaded up the option price history from June 1, 2005 to the end of April 2014 for SPY from into a database and created a simple strategy backtest in R.

The strategy is to purchase X shares of SPY stock with a starting capital of $100,000, and sell X rounded down to closest 100 shares of the Y% moneyness call option closest to 1M forward that has at least 100 open interest. At expiration if Price > Strike, then cash settle the loss otherwise the option expires worthless and you keep the premium. Then repeat for the next 1M forward date. For simplicity the strategy does not reinvest the proceeds from the covered calls back into underlying, and just accumulates the cash.

The backtest is performed on 1%, 2.5%, 5%, and 7.5% OTM 1M call options and the return and risk metrics are compared against buying and holding SPY without the covered calls.

Annualized Return Statistics

Overall the 5% OTM 1M covered calls provided the highest annualized return while 2.5% OTM provided the highest sharpe ratio although 2.5%, 5% and 7.5% OTM all provided returns and sharpe's that are likely not statistically different from each other.

Strategy Annualized Return Annualized Std Dev Annualized Sharpe (Rf=0%)
Buy and Hold Only 5.31 15.33 0.3463
1% OTM 5.07 11.56 0.4386
2.5% OTM 6.34 12.09 0.55246
5% OTM 6.52 13.22 0.493
7.5% OTM 6.19 13.86 0.4464
SPY Covered Call Analysis: Rolling 12 Month Performance Chart

Relative Performance Statistics

As you can see in the 12-month regression of returns, the covered call strategy significantly outperforms during market downturns such as 2008 as well as high volatility periods such as those from 2009 to 2011.

SPY Covered Call Analysis: Rolling 12 Month Alpha/Beta Regression Chart
Relative Performance Metrics 1% OTM vs SPY B&H 2.5% OTM vs SPY B&H 5% OTM vs SPY B&H 7.5% OTM vs SPY B&H
Alpha (%) 1.37 2.22 1.93 1.37
Beta 0.6556 0.7112 0.7937 0.8527
Beta+ 0.6277 0.6709 0.7456 0.8122
Beta- 0.7326 0.7584 0.8065 0.8543
R-squared 0.7979 0.8707 0.9334 0.9605
Correlation 0.8933 0.9331 0.9661 0.98
Information Ratio -0.0096 0.1277 0.1911 0.1816

Risk Metrics Statistics

Looking at the risk metrics the closer to ATM the higher the risk mitigation of the strategy with lower drawdowns, VaR and Expected Shortfall.

Risk Metric SPY B&H 1% OTM 2.5% OTM 5% OTM 7.5% OTM
Semi Deviation 9.96 7.3 7.5 8.1 8.5
Gain Deviation 9.9 7.2 7.3 7.8 8.3
Loss Deviation 10.9 9.3 9.1 9.2 9.6
Downside Deviation (Rf=0%) 9.5 7.2 7.4 7.9 8.4
Maximum Drawdown 56.43 39.53 40.71 45.12 48.61
Historical VaR (95%) -20 -14.1 -14.7 -16.3 -17.4
Historical ES (95%) -32.9 -25.9 -26.2 -27.4 -28.9

Overall Remarks

  • As excepted, a 1M covered call strategy on SPY provides about 1-2% of additional return vs only buy and hold. Additionally, the strategy provides some risk mitigation by lowering standard deviation, drawdowns and VaR.
  • Additional work should be done:
    1) To see if comparing the absolute level of implied vol to some minimus threshold can provide additional positive risk characteristics.
    2) Trying the covered call strategy on a different set of underlying stocks, for example covered calls on a value based factor portfolio or covered calls on a momentum portfolio. 3) Similar to 2), try the strategy with a basket of historically high vol vs historically low vol stocks.

By Jon Eickmeier | June 16, 2014 | analysis markets quantitative option backtest covered call

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