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Recent studies that have examined the profitability of cov- ered call strategies have focused primarily on S&P 500 index options.1 Whaley [2002] examines the Chicago Board Options Exchange (CBOE) Buy-Write Index (BXM), which involves buying the S&P 500 Index and selling one-month, at-the-money covered calls on monthly option expiration dates. He demon- strates that from June 1988 through December 2001, the BXM earned 1.12% mean monthly returns, versus 1.19% for the S&P 500, but with a substantially lower standard deviation of 2.66%, versus 4.10% for the S&P 500.2 These results highlight the attractive risk-ad- justed returns of passive covered call strategies and have contributed to their popularity.
Hill et al. [2006] examine the sources of profitability of the BXM strategy and empha- size the trade-offs between the benefits of receiving option premiums from selling calls versus the potential costs of having to sell the S&P 500 at the strike prices of the calls sold when the S&P 500 is considerably higher at expiration. Hill et al. [2006] demonstrate that the profitability of these strategies owes mainly to the tendency of at-the-money S&P 500 index options to be priced at implied volatilities that exceeded subsequent actual volatilities by an average 2.4 percentage points from 1990 through 2005. The varia- tion of the extent to which implied volatili- ties are greater than future one-month actual volatilities suggests that discretionary strate- gies of selling covered calls only when implied volatility is estimated to be more overpriced than usual could enhance risk-adjusted returns. Hill et al. [2006] do not explore this possibility but instead examine strate- gies of selling further-out-of-the-money calls when implied volatility is higher and closer- to-the-money calls when implied volatility is lower. These authors find, however, that the performances of these active strategies are only about in line with fixed-strike strategies that have similar initial average deltas.3
Figelman [2008] more formally decom- poses the returns of covered call strategies into a volatility premium-the difference between implied volatility and subsequent actual volatility over the life of options, the equity risk premium, and interest rate levels. The volatility premium reflects the benefit from the tendency of implied volatility to be higher than subsequent realized volatility, and the second factor reflects a reduction in the equity risk premium...