Benefits of Covered Call Strategy on DAX Index

Abstract

Recent academic studies on covered call strategies on the USA market have promising results. A strategy that lowers the standard deviation of returns and increases the average return must be a tempting strategy for an investor. But does the covered call strategy work as well in German markets? Also for the first time in academic literature of covered call strategy; benefits of partial volatility hedging and international diversification, between the USA and German markets, are analyzed.

Estimation period of this study begins from 1 January 1992 and lasts to 18 December 2009, consisting of 4545 daily return observations. Daily option values are calculated by using Black-Scholes model, using the daily spot values of VDAX as a proxy for volatility. Return of covered call strategy is then calculated from two components; returns of written call option and DAX index. Performance of covered call strategy is also analyzed by using various portfolio performance measurements. Volatility hedging is done by investing part of the covered call portfolio on spot VDAX. International diversification benefits of covered call strategy are analyzed using Markowitz’s (1952) theory.

Empirical findings indicate that covered call strategy offers better risk-adjusted return than simple index investment strategy, even when various portfolio performance measurements are considered. What makes the covered call strategy even more attractive is that it offers approximately same arithmetic mean return but with lower standard deviation than the simple index investment strategy does. Furthermore, risk-adjusted performance of covered call strategy can be improved by allocating part of the portfolio to spot VDAX. The covered call strategy is especially worthwhile during high volatile bear markets, like the recent financial crisis, compared to the simple index investment. When investing simultaneously on the USA and German markets, it is preferable to use covered call strategy instead of simple index investing.