Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance

CHAPTER 5

Leveraged Covered Calls with Futures

Chapter 4 reviewed many different types of calls and found that, on average, long-term deep-in-the-money calls are more profitable than short-term calls. In this chapter, we’ll use this knowledge to implement a classic strategy: the covered call fund.

Traditionally, covered calls are seen as low-risk, low-return strategies, but by applying leverage, we will create an investment that is capable of generating extremely high returns over short periods of time. This chapter analyzes and then backtests this strategy, both by year and in low- and high-volatility environments, in order to determine how it would have performed across a variety of market conditions.

COVERED CALLS AS A SOURCE OF INCOME

By selling an at-the-money call against a security in inventory, the owner forfeits additional appreciation for the period until expiry in exchange for the premium. This is because any appreciation will result in the exercise of the option. However, the owner will still be obligated to take any losses associated with the security, and could be left with an impaired asset.

Short-term covered calls are profitable historically because the premiums collected are, on average, higher than the losses taken on the security. This is the result of both the volatility premium, in which implied volatility is higher than historic volatility, and the rapid decay and hedging costs associated with short-term at-the-money options.

Profits are made when the ...