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Uncovering the Covered Call

For most option traders their first encounter with options was probably Covered Calls. Covered Calls are easy to understand, seem to have very little risk and convey the feeling of being more than just a “plain investor”. They are still the most popular option strategy.

Can You Outperform the Benchmark?


Because investors seemingly take for granted their understanding of Covered Calls they have been reluctant to put them under the microscope. This article will take a little different look at Covered Calls and suggest, perhaps, a more efficient way to accomplish the same goal.


The starting point has to be portfolio makeup. Many investors construct an investment portfolio that they believe will outperform some benchmark such as the S&P500. They don’t expect each and every position in the portfolio to outperform the benchmark --- nobody’s that good--- they just believe that their particular combination will outperform. If they don’t believe they can outperform, then I would suggest their first step should be to buy an ETF such as the SPDR S&P500 ETF (SPY). Even if one has constructed a portfolio combining individual stocks and ETFs one TRUTH remains …. Either they believe their individual selections will outperform a benchmark or they should replicate that benchmark through an ETF.


Let’s start with the investor that believes they can outperform and carefully and diligently selected 20 positions. This investor now wants to 1) hedge against a down market or 2) try to create additional income through Covered Calls. Though they are hedging against a drop, let’s say they want to leave a little room for an upside and so they write Covered Calls on each position with strikes, say, 1% Out-of-the-Money (OTM).


Now, let’s say they picked the 1% OTM strike perfectly and the overall portfolio went up 1%. Great planning … or was it? No portfolio has stocks that move up exactly the same. In any typical portfolio some stocks will do better than others at different times. If everything was the same, why own more than one stock? So, if a portfolio went up 1%, it just makes sense to assume that some stocks went up more than 1%, some less than 1% and some may even have gone down.


That means that though the portfolio went up 1%, some stocks, by virtue of the Covered Calls didn’t realize the growth above 1% and were “called away”. The portfolio is left only with the “under-performers”. As a result, the portfolio didn’t realize its actual potential, though the strikes were apparently, set perfectly.


As a result of this, a carefully structured portfolio will not perform as intended if subjected to Covered Calls. Let me drive this home using a simple two position portfolio as an example. Let’s say that the Covered Calls were 1% OTM. One position goes up 6% and the other goes down 5%. The portfolio gained 1%. However, the Covered Calls capped any individual gains at 1%. As a result, a portfolio that should have gone up 1% actually went down 4%. I call this the “over/under-achiever“ problem.


Now, some will argue that they could just write the OTM strikes at different levels on different stocks. Well, if anyone can pick outperformers in their own portfolio that correctly, why not just junk the underperforming stocks and stick with the outperformers?


There is a better way … a methodology that will enable the investor to reap these excess returns and realize the outperformance they were planning on. It’s nothing earthshattering. It’s nothing difficult. It’s done all the time.




If you are not a member yet, you can join our forum discussions for answers to all your options questions.


The Covered Call Alternative


Instead of writing COVERED CALLS on selected positions, use Naked Calls against the benchmark.


So, let’s say that our investor, instead of writing Covered Calls on 20 positions, just wrote a Naked Index Call on the S&P500 Index (SPX). Well, first it’s one trade and not 20 trades. Easier to implement, maintain and less costly … not to mention many more expiry dates. It is also Cash Settled and avoids the problem of having a position being “called away”.


Let’s look at what would happen if the investor’s portfolio outperformed the benchmark and went up, say 1.2% while SPX only went up 1%. Inasmuch as their actual holding was not subjected to any call, they realized the entire 1.2% upswing. Nothing is called away. The SPX, having gone up somewhat less at only 1%, was 100% profit with no give back.


As another example, let’s say that a portfolio went up 2% and the SPX went up only 1.5%. The Naked call on SPX, landing In-the-money .5%, will reduce the overall portfolio value by .5% through a cash debit. Nothing is automatically sold. The investor can either meet that .5% using their available cash or select to sell whatever they want. But, after the smoke clears, their portfolio is still AT LEAST .5% ahead of where it would have been with Covered Calls.


I say AT LEAST because if there were substantial outperformers and some laggards as discussed earlier the net could be much less.


What if the investor didn’t want to hedge all 20 positions and just, say 1/2 the portfolio value? With individual Covered Calls one must select which positions and what strikes. With a Naked Call, just select the appropriate number of calls and it’s done.


This can be extended to individual stocks as well. Let’s sat the investor had a tech stock and wanted to sell a covered call. Well, they either believe their tech stock will outperform QQQ or not. If they believe it will, then just sell a sufficient number of calls on QQQ to mimic the individual position.


What if one has a portfolio that leans more toward small caps, tech, international, etc.? This is easily remedied by writing naked calls on multiple indices. For instance, a portfolio that leans towards small cap, could write naked calls, say 75% on SPX and 25% on RUT. Or whatever ratio reflects the investors regimen.


The Devil is in the Details


But, and this is important when writing naked calls …. Make sure the underlying benchmark (or combination of benchmarks) is representative of your actual holdings. One should avoid a mismatch … unless it is deliberate (and that’s for another article).


The next important point to keep in mind is this method works ONLY if the investor selected portfolio outperforms the benchmark. If the benchmark outperforms the portfolio, they might have been better off with COVERED CALLS. I say “might” because writing Covered Calls always runs the risk of the over/under-achiever problem and one can never know how bad it can get.


What about Covered Calls on an index ETF such as QQQ or SPY? The “over/under achiever” problem doesn’t exist as the ETF, by its very nature, “blends” the individual stocks. But there is one thing you can do to get a better experience if your portfolio is in a taxable account (not an IRA or ROTH).


When one sells (writes) an option on equities, net gain is ordinary income, regardless of holding period and taxed at the highest applicable rate. On the other hand, options on indices such as SPX, RUT and NDX are IRC 1256 contracts and afforded special tax treatment. Any net gains are 60% Long Term Capital Gains and 40% Short Term Capital gains (so called 60/40 rule). This holds even when they are sold short and regardless of holding period. The 60% afforded LTCG can mean a significant reduction in tax, especially to those in higher tax brackets.


Assuming one expects to gain on selling an option, they will pay less tax if they sell the index option (such as SPX) instead of the corresponding equity option (SPY).


Any investor that is selling options on SPY, QQQ or IWM may want to consider switching to SPX, NDX or RUT if the tax savings are significant.


Rounding out the issue, selling naked index calls does impact margin and requires sufficient trading authority. Unless the investor can manage these “hurdles”, then they might as well just default to Covered Calls and hope it works out. When all is said and done, perhaps the additional knowledge and trading authority required for naked calls is the real reason people don’t hear much about these methods.




Covered Call strategies are often taken for granted without too much thought. That might work fine for the occasional investor “playing around” or trying a few trades. However, for the serious investor that is considering a long term or repetitive strategy designed to augment income or provide some hedge, Covered Calls present some problems. Selling naked calls on a replicate benchmark through either a single index option or combination of index options will almost surely return better results.


Once you boil it all down, the Naked Call is superior BUT it tests the investor’s equity selection. That is, it’s not about one option versus another, but whether the investor has the requisite skills to assemble a portfolio that can beat a benchmark or combination of benchmarks. If the investor is a chronic underperformer maybe the real answer isn’t Covered Calls versus Naked Calls, but something else… maybe professional money managers or simple index ETFs. On the other hand, if the investor is a solid investor, they have an opportunity to even expand upon that record by abandoning Covered Calls in favor of Naked Calls.


Ken Reel is a well known and respected Seeking Alpha Contributor with over 100 articles. He has worked in the financial service industry for 40 years. Ken's area of expertise is risk management and complex financial products. He has been a frequent speaker, on behalf of many financial firms, to financial professionals across the country. He has extensive experience in statistics and actuarial science.


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We want to hear from you!

Dear Ken,

I´ve been spending endless hours on your articles on SA, so this feels like I´m meeting an old friend again. Your hedging strategies are really game changing for my investments strategies. I´d like to thank the guys at steadyoptions to bring you on board here. And of course many thanks to you, Ken, for the massive amount of time and patience (!) you spend while teaching us. This is highly appreciated.

Assuming a portfolio that is made up of SPY shares only. Is there a covered call strategy you can recommend to increase profits or to contribute to recover the costs of the hedge?

I know you wrote about continously writing 2%-OTM monthly calls in some of your articles on SA a while ago. Is this still a something you recommend? One aspect to this is that with the current low volatility there´s not much premium to be made with 2% OTM.




Edited by HonnyNo3

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Hi Honny,


Thanks for the kind words. It's nice to have place where I can continue writing about options ... and actually ... where better than a site devoted to options.

It's difficult to recommend any specific strategy as each person's portfolio, objectives, time frames, experience and risk tolerance varies.

That said, as a generic recommendation, there are studies indicating that 2% OTM seems to be the "sweet spot". I think one can improve a little on that by adjusting the strike on a SEASONAL basis. That is, go somewhat further OTM during Q4 and Q1, and closer to ATM in August, Sept and October. Also, adjusting, in a similar manner, around market tops and drops ... going closer ATM near tops and further OTM after drops. Just a probability play.

If we look at the Seasonal and Top scenarios, and look at todays market... both factors favor being closer to ATM, or even ITM.

However, these studies don't take into account the existence of any hedging strategies that might already be in place, such as ratio diagonal calendars. So, if you are fully hedged with such a strategy, then layering a 2% OTM covered call (or any covered call) on top of that, would be redundant and carries some risk.

I would be more inclined to take advantage of any existing hedge and increase risk by selling DeepOTM naked puts if there was a sizeable pullback. I'll probably be writing more about this on SteadyOptions next time.

Hope this is what you were looking for, if not, let me know.


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Hi Ken,

thanks for your prompt answer. Yes, this is what I was looking for.

What keeps me thinking is your remark "...that would be redundant and carries some risk".

Again assuming a 100% SPY portfolio that is fully hedged with ratio diagonal calenders. What additional risk is added by selling monthly SPY OTM-Calls? I´m wondering because, assuming that the 2%-OTM-Monthly-Short-Call strategy is a profitable long-term standalone portfolio strategy, why would it add additional risks as an add-on component to an existing portfolio; maybe kind of looking at the whole portfolio as two portfolio tranches and pretending the 2%-OTM-Monthly-Short-Calls are just naked calls.

Or another way to look at it: Assuming a hedged portfolio that is 100% Nikkei exposure and adding the 2%-OTM-Monthly-SPY-Short-Call strategy. Ignoring potential diversification benefits for our discussion, would you still say that this adds some risk?




P.S. sorry for my bumpy english, I´m not a native english speaker.

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Hi Honny,

When one sets up a diagonal ratio calendar spread the "risk" is greater on a  sharp up-move than a down move. This is because the weekly strike can be over-run.

Selling 2% OTM calls, doubles down on that risk. It  also lowers the DELTA of the portfolio to below .50, indicating a bear-stance. If that's what's desired... then O.K., but I look for a slightly to modest bull stance.

Also, just to set the record straight .. the 2% OTM strike is for a COVERED CALL not a naked call.  I haven't seen any research on Naked Calls, but I would suspect that there is little probability of a Naked Call being profitable without consideration of market timing.

Hope this helps.

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I'd like to welcome you as well -- we used to message occasionally on SA in 2011 -- you're articles from then assisted in creating the Anchor Strategy.  It's gone through a couple of evolution and tweaks since then, but I doubt it'd be where it is today without your input 5 or so years ago.

That said, moving to your article, it leaves me a little confused.

The Problem:

I completely understand the argument breaking down covered calls, as I've seen that happen repeatedly.  e.g. own stocks ABC and DEF, , sell 2% OTM calls, stock ABC goes up 8%, stock DEF goes down 5%.  ABC gets called away, you lock in a 2% gain (plus the option premium), your DEF option expires, you keep the premium, but your overall portfolio is down because of the DEF draft and as you did not get to participate in the other 6% move on ABC.

It seems to me that your advocating creating a stock portfolio that will trade either 100% correlated with an index or, even better, out perform an index.  You then own the stocks and sell naked calls against the index (as opposed to against the stocks themselves).  Let's say we do that and create a basket of 10 stocks that we predict will go up more than 2% in the next month.  So we sell naked calls on SPX (or whatever index we want) 2% OTM.  Let's look at the various scenarios:

The Results:

A.  Basket of stocks goes up 2% or more and SPX does not go up 2%.  This is the best case scenario, as your stocks outperform the index and you get to keep the entire premium from selling naked calls.  However, depending on the premium received, you may not be better off than if you had sold against the basket of stocks.  Since indexes are less volatile, you will receive less premium from selling naked calls.  So this strategy is only better if:

          The basket of stocks + option premium received from the naked index calls >  The basket of stocks + option premiums from covered    calls.

An example -- You own 10 stocks and sell 2% OTM SPX for a 0.5% premium.  OR -- you own 10 stocks and sell 2% OTM for a 1% premium.  In that case, to be better off, your basket of stocks has to gain MORE than 2.5% to break even (2% plus spread in option premiums). 

B.  Basket of stocks goes up over 2% (let's say 5%) and SPX goes up, but less than the basket of stocks (so 4%).  This is a bad situation as well, as you now have to buy SPX at a 4% higher price.  So you gain 5% from your portfolio but you lose 4% (less the premium you received) when you have to buy SPX so it can be delivered.  Or if you don't want to get assigned, you can always buy the call back, but the loss will be the same either way.  To me this does not seem to be a "cure" for the problem identified, as your gains are limited to the spread between your basket of stocks' gains and the SPX gains;

C.  Basket of stocks goes up over 2% (let's say 3%) and SPX goes up MORE (let's say 5%).  Here, as in with B, your basket goes up 3%, and you earn money from the premium of selling naked calls on SPX, but then you lose 5% when you have to close (or get assigned) the SPX options.  So you actually end up losing money in this scenario and are much worse off than having just sold covered calls;

D.  Basket of stocks does not go up, SPX does -- this is the same problem as with C, but worse, as you lose because your stock basket went down AND you lost on the naked call when assigned/closing; or

E.  Basket of stocks goes down and SPX goes down -- here you are better off than just owning the stocks, as you captured some premium, but you are WORSE off then if you had sold covered calls on just your stocks (as indexes are less volatile, you'll have received less premium selling naked call on it then if you had on your stocks).


So selling naked calls this way would seem to ONLY be better than covered calls when your basket of stocks gains more than SPX AND gains more than the amount out of money (2% in the above example) PLUS the spread on premiums. 

Given the theatrical unlimited loss on the naked calls, I don't see how this helps increase returns and reduce risk.  You are worse off in every possible scenario, other than when you have built a basket of stocks that outperforms the index by more than the spread in premiums.  If I'm that confident that I can pick stocks that will consistently outperform an index, I'd rather use traditional pairs trading strategies.  That way I make money in ALL market conditions, as long as my basket outperforms the index.  Since your premise is built on me beating the market by picking stocks (something I gave up on long ago), why would you not pairs trade instead of using naked calls?

Of course it's early Monday morning here and I haven't had my tea yet, so I might have missed something. 

That said, welcome again -- very glad to have you here. 



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Hi Ken,

thanks for the clarification. For sure I missed the fact that the mentioned studies are all about covered calls not naked calls.




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Hi cwelsh,


Thanks for taking the time to write such a detailed and informative response.

Almost anyone can construct a scenario that favors almost any position they want. The question is what is more probable? Let's look at a few items.

You are correct in noting that a naked index call will produce less premium than individual stocks. However, multiple positions incur greater costs and depending upon the issues, less favorable bid/ask spreads. But let's ignore this.

Option premiums are priced on many factors. The fact that a stock may credit a higher premium is reflective of it's greater probability in over-running that strike. So, over time, one may credit greater premium, but one will experience greater over-run. But, let's ignore that.


Let's look at the problems with the basket approach... that is uneven returns on individual components.

Assume one buys the individual components of the S&P500...that's right....500 stocks. They write 500 calls at a strike 1% OTM a premium credit of, say XX$. Compare that to a naked call on SPX and only credits .75XX$ premium. Forget about the efficiencies in them even.


The S&P 500 goes up by 1%. The write on SPX pockets the full premium.

Let's look at the 500 stock basket. Certainly some of the 500 have gone beyond the strike. So, the basket returns NOT 1%, but something less. How much less...choose your flavor. The seminal issue then, is the amount lost on the over-runs greater or lesser than the extra premium of .25XX$?

Theoretical probability says they are even odds ... that is, the over-run is most probable to match the additional premium (if not one could arbitrage the S&P500 against itself).

Now, when we swing to two different and independent portfolios, one of which outperforms the other... the probability is that the over-runs exceed the extra premium. The best way I can explain this is to illustrate the "custom portfolio" goes up 5% when the naked goes up 1%.  So, it is possible that there is a net debit not credit on the custom. Once we factor in all the combinations  of over-runs exceeding the credit increases the probability increases and diverges from equilibrium.

So, to sum up ... there are scenarios that work in favor of one over the other. However, the probabilities favor naked calls PROVIDED the custom portfolio outperforms. If the custom doesn't outperform, it may still be better, but less probable.


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I don't disagree at all (and the arbitrage on the index makes the point very clearly).  I just think that, even if your custom portfolio outperforms, you're not getting adequate return for the risk. 

This is simply because the only time holding the basket of stocks and selling naked SPX puts is a good decision is if your basket goes up and SPX goes up to the strike you sold, and no higher.  Anything more you start to lose on SPX, so now your profits are simply the spread between what your basket gains and what SPX gains (plus the premium you received).

For example, let's say we have a basket of stocks that are worth $1,000,000.00, SPX is at 1960 (for easy math).  We predict that the market is going to go up 2% this month and think our basket will outperform.  So we sell 5 contracts of the 2000 call (aprx 2% more than 1960) for $20.00, which gives us $10,000.00 in premium.  Possible results:


A.  Basket of stocks goes up 2% (or more) and SPX goes up 2% or less (thereby options expiring worthless).  Your profit is now your gain in your basket plus $10,000.00.

B.  Basket of stocks goes up more than 2% (let's say 5%) and SPX goes up, but not as much (let's say 4%).  You have made $50,000.00 on your basket, $10,000.00 from the premium, but then lost aprx. $20,000.00 on your naked options.  (4% gain from 1960 is about 2040, 2000 call = $40 loss x 5 x100).  So your total gain is $40,000.00 -- worse than if you just held the stocks without any options.  In this scenario, your gains never exceed the spread between your basket and SPX (plus the premium).  It doesn't matter how high you go -- if your basket gains 20% and SPX gains 19% -- you are in the exact same position had SPX gone up 4% and your basket 5%.  So your gains are limited -- just as they are with covered calls.  With a covered call your gain is limited to the premium you received and how far OTM you went.  (If you sell 4% OTM, you won't gain more than 4% plus the premium received).  So in either case, you've limited your gains.

C.  Any other scenario -- worse off than covered call.  Perhaps the worst scenario is if both your basket and SPX go up -- and SPX goes up more.  If your basket goes up 10% and SPX goes up 12%, you would actually LOSE money.  As opposed to with a covered call, where you will never lose if the market goes up, you just might gain less.

I'm not trying to say naked calls are bad, I use them myself.  I just don't agree that holding a basket of stocks I THINK will outperform an index and selling naked calls on the index is a better alternative to selling covered calls. Yes, there are a few instances where it might be SLIGHTLY better, but that requires me to be correct on almost every pick I make -- which stocks will out perform, how much they will out perform, and when they will out perform.  No thank you.

But, I still did enjoy the piece. 

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