Behavioral Aspects of Covered Call Writing: An Empirical Investigation

Abstract

Various explanations for the popularity of covered call option strategies have been explored in the literature. According to Shefrin and Statman [1993], framing and risk aversion can help justify its attractiveness to investors. Applying prospect theory and hedonic framing, these authors predict that in a world of frame dependence an investor that is sufficiently risk averse in the domain of gains will prefer a covered call position over a stock only position and that certain covered call designs will be preferred despite identical cash flows. To date, the relationship among framing, risk aversion, and covered call writing has not been empirically tested. We gather empirical evidence to complete this gap in the literature. We find highly significant empirical evidence for a pronounced framing effect with respect to different covered call designs with equal net cash flows as well as covered calls in general. We find only scarce empirical evidence for a relationship between risk aversion in the domain of gains and a preference for covered calls. In order to observe a positive relationship between risk aversion and covered call writing, investors with above average risk aversion seem to be required.

Keywords:

• Behavioral finance
• Covered call writing
• Risk aversion
• Framing
• Options

ACKNOWLEDGMENT

The authors would like to thank the editor, an anonymous reviewer and Hersh Shefrin for their constructive guidance and comments on earlier versions of this paper.

Notes

1. The term covered call generally refers to overwrites, i.e. to short a call option on a stock that one already owns, as well as buy-writes, that is, to first buy a stock and then to short a call option on this stock (Figlewski, Silber and Subrahmanyam [1990]).

2. For more information about these products, see www.cboe.com or www.euronext.com.

3. The BMX is a hypothetical buy-write strategy that entails the simultaneous purchase of the S&P 500 and the shorting of an at-the-money S&P 500 Index call option (ww.cboe.com).

4. While the Sharpe ratio measures return relative to upside and downside variability, the Sortino ratio measures return only relative to its downside variability. It is used as a measure of risk-adjusted return (Sortino and Forsey [1996]).

5. The Upside Potential Ratio is defined as the upside potential over the downside risk measure. As such, it is used to identify strategies with stable growth for a given minimum return (Sortino, van der Meer and Plantinga [1999]).

6. We thank an anonymous reviewer for noting that besides concavity of the value function in the domain of gains, subcertainty (Kahneman and Tversky [1979]) may also drive investors’ preference for covered calls over stock-only positions. We concur, but an investigation of this effect is beyond the current study's scope.

7. DRCs and RCBs are similar to a combination of zero-coupon bonds or regular bonds with a short put option on stocks (Breuer and Perst [2007]).

8. We thank an anonymous reviewer for noting that in case probabilities are small, not 50–50 as in Shefrin and Statman [1993] and here, investors may exhibit risk seeking in the domain of gains, even with concave utility.

9. We thank an anonymous reviewer for noting that our graphical display of the binominal case used by Shefrin and Statman [1993] may mask the true payoff pattern of covered calls (e.g., Figure 2). Future research should employ more realistic examples that also include intermediate payoffs.