For years, I have enjoyed reading academic papers by Cliff Asness and the team at AQR Capital. In the IOI training class on options, I mention one paper by AQR’s Frazzini entitled “Buffett’s Alpha” as a formative one for me in conceiving of IOI’s unique way of measuring and managing leverage in a portfolio.

But I had always associated AQR with quantitative factor investing, value / momentum overlays, and “risk parity” strategies. Imagine my surprise when a friend passed along an AQR paper about implementing a covered call strategy entitled Covered Call Strategies: One Fact and Eight Myths! (I’ve posted a copy of the paper in the IOI Knowledge Base as well)

To me the most interesting idea of the paper was that the authors (Israelov and Nielsen) decomposed the returns of a covered call strategy into two factors: one which gives an investor access to earning the market risk premium and another which gives access to the “volatility premium.” This is a little wonkish for a blog posting, but anyone enrolling in the IOI Master Class on Options will get to hear about it!

The most accessible part of the paper for most investors is the “one fact, eight myths” piece. I’ve listed these below along with my brief comments. You’ll see that I disagree with the premise of a few of the myths, but that is mainly because of a difference in conceptual framework. AQR has a strong bias for a belief in market efficiency (Asness was a student of Eugene Fama’s at the University of Chicago), which assumes that the present price of the stock is its true intrinsic value. This is a notion that I completely reject (and have good evidence for doing so), so we’re bound not to see eye to eye on everything.

The paper is a good one, if a little technical, and I hope you get something from my comments below as well.


  • Covered calls provide long equity and short volatility exposure: Yes! This is the wonkish point above. The short volatility exposure is what we are trying to maximize when affecting this strategy and is the reason I recommend always selling options ATM.


  • Risk exposure can be expressed in a payoff diagram: Totally agree. Those hockey stick diagrams are only valid at one instance in time and don’t give an accurate idea of the risks involved in any option strategy. For that, I much prefer the IOI diagrams!
  • Covered calls provide downside protection: Totally agree! I can’t believe how many people think they get downside protection from selling calls. Ridiculous!
  • Covered calls generate income: I laughed when I saw this. The authors are right — one doesn’t generate income if one ends up holding the stock at option expiration. Instead, one now has access to the stock’s upside potential at some effective buy price. I talk about this in the IOI 100-series course on options and go into more detail about it in the Options Master Class.
  • Covered calls on high-volatility stocks and / or shorter-dated options provide higher yield: Here is one where AQR’s market efficiency bias makes me quibble. The authors point out that selling a covered call on a high volatility stock is riskier, so the risk-adjusted return is lower. Those who have taken the IOI 100 series courses know that volatility does not equal risk! I would say that covered calls written on a high volatility stock don’t generate better yields if you don’t know how to estimate the value of a stock or if you overestimate its value. The point about shorter-dated options is one that I talk about with regards to the dangers of annualization of returns.
  • Time decay of written options works in your favor: Again, this is a myth only as long as you believe that markets are efficient.
  • Covered calls are appropriate if you have a neutral or moderately bullish view: Totally agree. The authors point out that the view that a covered call seller should have is one about the volatility, not the directionality of the stock. Selling covered calls on stocks without regard for what you’re getting paid for volatility is at best an inefficient way to go.
  • Covered calls pay you for doing what you were going to do anyway: Totally agree. Here, the authors are talking about selling covered calls as a means of “taking profit.” I can’t stand it when people talk about taking profit using covered calls!
  • Covered calls allow you to buy a stock at a discounted price: Kind-of agree. The authors talk about a person who would sell an OTM put to buy a stock if it falls. That is, in my opinion, a silly strategy. However, if you have a good idea of the value of a stock and sell a put to get some contingent exposure at a lower effective buy price, I’m all for it!

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