This will start a little technical (and seemingly off-topic), but should quickly get relevant and may cause you to see some things in a new light.
To begin, we need to discuss synthetic securities, and I will use stocks as the easiest one to understand. Suppose you have a non-dividend-paying stock that is trading at $50 (we could use any security that has options on it but for simplicity I will use the term “stock” throughout this piece, but you could replace it with the generic term “the underlying” with no loss of applicability if you like). If you wanted to “own” (replicate) the upside of that stock over the next three months, you could buy a call with a $50 strike price maturing in three months. If you wanted to “own” the downside of that stock over the next three months (I know it sounds weird – why would you want to do that? – but stay with me) you would sell a put with a $50 strike price maturing in three months. You could also purchase a t-bill that matured in three months at $50. (You’ll see why that matters shortly.)
Now, the interesting thing is that we can create any one of these instruments with any three of the others. For example, the stock we have been discussing is exactly equal to being long the call, short the put, and long the t-bill. Mathematically, it looks like this:
S = C – P + T
Any value that the left of the equation goes to in three months the right side will match perfectly. These relationships must hold because if there were an inequality, it would allow a risk-free arbitrage opportunity. For example, if the stock was too expensive you could short the stock and go long the instruments on the right and arbitrage the difference.
The interesting part is that with simple algebra we can rearrange this equation. For example, we can move the call option to the other side like this:
S – C = T – P
The left side of this equation is covered call writing (long the stock, short the call) which is widely considered a relatively safe “widows and orphans” type strategy. Perhaps you have noticed though that it is exactly the same as buying T-bills and selling naked puts on stocks – a strategy that most folks would consider insanely risky!
We can also rearrange to remove the risk of the stock. Suppose we are long the stock, short the call (we sold the upside), and long the put (we bought protection against the downside):
S – C + P = T
This is a really tight collar and as you can see gives you T-bill returns. (Before you get clever ideas, the tax laws would consider this a constructive sale of a stock position.)
Now in real life there are complications like dividends and the fact that the options are usually purchased out of the money. These changes make the math complicated but don’t change the underlying reality – when you do covered call writing, you are effectively buying bonds and selling naked puts, or, as the saying goes, picking up nickels in front of a steamroller.
I don’t think it changes the overall point that this “conservative” strategy is actually extremely risky, but there are two reasons that selling calls can add a little value. (The same holds for selling puts for that matter – because of the equation above I can make puts out of calls or calls out of puts by combining with stocks and T-bills – just rearrange the equation – and “put/call parity”, as it is called, exists.) First, the price of the option is based on expected volatility and historically the expected volatility is higher than the volatility that is actually realized. In short, options are probably a little bit too expensive on average (though Nassim Taleb, of Black Swan fame would argue the opposite and I’m not sure he’s wrong) so selling them (as in a covered call writing strategy) might earn a small premium. Second, there is a well-known effect called the “volatility smile” where if you graph the strike prices of the option on the x-axis and the volatility of the stock implied by the market prices on the y-axis it should be a straight line, but it generally forms a “smile” which just means that the further away from the current market price the strike price is (i.e. the more out-of-the-money or in-the-money an option is), the more expensive it is (options on stocks with higher volatilities are more expensive). Thus, out-of-the-money options are potentially too expensive. There isn’t a clear reason why this should be so, but it may be related to people’s preference for lottery-type payoffs and willingness to insure against catastrophic losses even at higher prices. Here is a graph of the volatility smile:
In short, I would caution against using covered-call-writing as a strategy unless you were also comfortable with owning a bond portfolio and writing naked puts – it’s the same thing!