Revisiting Covered Calls and Protective Puts: A Tale of Two Strategies
8 Pages Posted: 19 Mar 2021
Date Written: February 15, 2021
This paper examines the historical risk-adjusted returns of two hedging strategies designed to minimize downside market risk: Protective-puts and covered-calls, using US market data from 1993 to 2020. Here, we find that covered-call strategies significantly outperform the buy-and-hold strategy on a raw and risk-adjusted basis over the entire sample and these excess returns appear to remain persistent over time. We also find the opposite results hold for the protective put strategy: This strategy not only significantly underperforms the buy-and-hold strategy from a raw and risk-adjusted return standpoint, it actually significantly increases the probability of incurring losses each month. Finally, we evaluate the overall utility of various covered call strategies for loss averse investors, using the standard prospect theory utility function. Here, we find that out-of-the-money covered-call options yield the highest utilities for investors with less than average loss aversion, while in-the-money covered call options become more favorable as loss aversion increases.
Keywords: covered calls; trading strategies; protective puts; prospect theory
JEL Classification: G02, G14
Suggested Citation: Suggested Citation