Negotiating the Devil's Bargain

Balancing Equity and Volatility Risk Premia with Covered Calls

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Setting the Table:

• Markets have been calmer this week as even a PCE reading couldn’t move the indices very much.  Futures look mixed this morning and we have a few Fed speakers on the agenda for Friday afternoon. 

• Broadly liquidity has remained solid, continuing an uptrend on the year, even as the volumes have slipped a little with a roughly 5% below average week.

  

• Thirty day VRP has remained negative for several days now, as these upward moves were enough to unseat relatively low implied volatility pricing. ATM 30 day vol in SPX is still only 11%, so expectations haven’t changed much.

  

Review:

• Today we’re going to take a slightly different approach, and review a piece of research that was published regarding covered call strategies. The authors of the paper are Roni Israelov, a quant researcher at AQR focused on volatility, and David Nze Ndong from NDVR. You can find the full paper, “A Devil's Bargain: When Generating Income Undermines Investment Returns”,  here. 

• The paper investigates the theme of whether covered call options strategies motivated by passive income are in fact making a “Devil’s Bargain.” Focusing on SPX options strategies, they demonstrate a negative relationship between the level of income demanded and the overall returns of the strategy. 

• Below we’ll parse through some of the notable observations and consider what the implications are for strategy design here. As the authors themselves indicate, covered calls are not “bad” per se, but certain conditions must be met and trade-offs recognized. 

Identify:

• The explosion of derivative income funds remains unabated. There are nearly 100 different funds in the Morningstar “Derivative Income” category, and they trade calls and puts at every tenor and frequency. We have the Daily Theta Cliff in QQQY, but also the special sauce of Goldman Sach’s “US EQ Div and Prem Fund” that has nearly $3B in assets. 

• Most of these funds follow a fairly mechanical strategy. Every day/week/month according to their mandate, they find the strikes and expirations to deliver premium, and are often paying regular and sizable distributions. 

  • Since inception, QQQY has paid sizable dividends ($5.30 total) but the stock price has gone down almost as much. It’s up roughly 9% gross since inception, in a market where the underlying is up about 15%.

    

• Distributions are an important part of an investors portfolio, and dividends have sought to achieve this cash flow for many years. The question is whether writing the options risk is the best way to do that, or perhaps an investor is better off simply lightening their delta?

• The complexity of individual investment profiles precludes the ability to make blanket statements. Absolute alpha is not always the goal, and “under performing” strategies with lower volatility can be desirable. There are also complex tax questions due to holding periods or income that further obfuscate any true answer.