A Devil's Bargain: When Generating Income Undermines Investment Returns

Abstract

Many investors are motivated by passive income. Dividend income seeking strategies have a long history. More recently, interest in derivative income strategies – such as covered calls and put underwriting – continues to develop. Do high derivative income covered calls tend to deliver higher total returns? No. In fact, the relationship goes the other way. We demonstrate a strong negative mechanical relationship between expected total return and derivative income for covered call strategies. We empirically validate this relationship over a nearly 25-year period on S&P 500 Index covered call strategies. Those who have sought out and allocated to such strategies without taking into account this tradeoff might have made a devil’s bargain.

Keywords: Covered Call, Covered Calls, Call Overwriting, Overwriting, Options, Volatility Risk Premium, Variance Risk Premium, BuyWrite, Buy-Write, PutWrite, Put-Write, Yield, Income, Derivative Income

JEL Classification: G00, G10, G11, G12, G13