Do Covered Calls Improve Sharpe Ratios?

Covered calls are a popular basic options strategy in practically all markets.

Are they better than simply trading or investing securities per their basic linear exposure?

We take a look through the lens of risk-adjusted returns (i.e., Sharpe ratios).

Key Takeaways – Do Covered Calls Improve Sharpe Ratios?

• Covered call strategies tend to boost Sharpe ratios by 36-73% versus holding index funds.
• The improvement is mainly due to 30-40% lower portfolio volatility, with only a 0.5-1.5% annual return reduction.
• Covered calls perform best in flat, volatile, or declining markets, but can lag in strong bull markets.
• Key trade-offs: negatively skewed returns, lost upside in big rallies, and higher expenses/taxes.
• Delta-hedged versions further improve risk-adjusted results.
  • But this is harder to implement for small traders.
• Most suitable for those valuing income and lower risk over maximum long-term gains.

Key Finding: Consistent Risk-Adjusted Return Enhancement

Research consistently demonstrates that covered call strategies improve Sharpe ratios by 36-73% compared to simply holding index funds directly.

Multiple academic studies (linked in our table below) spanning different time periods and market environments show this risk-adjusted return enhancement.

Average improvement across studies: +46% in Sharpe ratio

Alternative Study

I found an interesting bachelor’s thesis study by Tomáš Ježo from 2023 titled Effect of covered calls on portfolio performance.

These are the key takeaways:

• This thesis finds no statistically significant difference in overall performance between covered call strategies and a buy-and-hold SPY ETF over 2009-2023.
• ATM covered calls delivered lower annualized returns (8% vs. 13% for SPY), but reduced volatility by 30% (12% vs. 18%).
  • This makes sense as it was an overall good period for the market. ATM annual calls tend to provide 7-8% premiums.
• The lower risk (volatility) of covered calls was consistent, but more extreme negative skew and higher kurtosis were observed.
• During extended bull or recovery periods, covered calls underperformed in returns due to capped upside.
• 2% and 5% OTM covered calls outperformed the benchmark in annualized returns (15–16%) with somewhat lower or similar volatility, but again with no statistically significant edge.
• Covered calls outperformed buy-and-hold on most trading days, but missed major upward moves.
• The practical appeal of covered calls (especially OTM) lies in lower volatility, but results may be eroded by real-world taxes and transaction costs, which were not included in the analysis.

Primary Mechanism: Volatility Reduction

The Sharpe ratio enhancement primarily comes from substantial volatility reduction with only modest return reduction.

Covered calls typically reduce portfolio volatility by 30-40% while sacrificing only 0.5-1.5% in annual returns.

Volatility Drag Benefit

Lower volatility provides an additional advantage through reduced “volatility drag.”

The geometric return (what investors actually experience) is approximately:

Geometric Return ≈ Arithmetic Return – (Volatility²/2)

For example, reducing volatility from 20% to 13% decreases volatility drag from 2.0% to 0.8%, providing a 1.2% annual compounding benefit.

Performance Characteristics by Market Environment

Covered call strategies exhibit distinct performance patterns depending on market conditions:

Outperformance scenarios:

• Flat or declining markets
• High volatility environments
• Periods of market uncertainty

Underperformance scenarios:

• Strong bull market rallies
• Sustained low-volatility uptrends
• When markets exceed strike prices frequently

Important Trade-offs and Considerations

Negative Skewness Risk

Covered calls create negatively skewed return distributions.

While they produce many small gains from premium collection, they eliminate the potential for large positive returns while retaining downside risk (albeit reduced by premiums collected)

Cost Considerations

Implementation costs can erode benefits:

• Covered call ETFs typically charge 0.60-0.68% expense ratios (as a rough average, can be higher or lower) vs. 0.09% for standard index funds
• Transaction costs from frequent option writing
• Potential tax inefficiencies from option income

Market Timing Sensitivity

The AQR study found that dynamic equity exposure (essentially market timing) was the least valuable component of covered call strategies, contributing about 25% of risk with minimal reward.

Risk-managed versions that hedge this exposure showed even better Sharpe ratio improvements.

Enhanced Strategies: Delta-Hedged Covered Calls

Advanced implementations using delta-hedging to neutralize uncompensated market timing risk showed superior results.

The CXO Advisory study demonstrated that hedged covered calls achieved a 0.52 Sharpe ratio versus 0.37 for basic covered calls.

Conclusion

The evidence strongly supports that covered call strategies can improve Sharpe ratios by 36-73% compared to holding index funds directly.

The enhancement comes primarily from volatility reduction (typically 30-40%) with modest return sacrifice (0.5-1.5% annually).

At the same time, traders/investors must accept negatively skewed return distributions and higher implementation costs.

The strategy works best for traders or investors prioritizing risk-adjusted returns over maximum absolute returns, particularly those whose goals are geared more toward income and lower volatility.

The effectiveness varies significantly with market conditions. They perform better in flat or declining markets while underperforming during strong bull runs.