Backtesting the Covered Call Strategy: Income vs. Opportunity Cost

# Backtesting the Covered Call Strategy: Income vs. Opportunity Cost

Covered calls are perhaps the most popular options strategy among retail investors. Own 100 shares, sell a call against them, collect premium. It sounds like free money. But our backtest reveals that the income comes at a very real cost that most investors underestimate.

The Setup

We backtested selling monthly covered calls on SPY from 2010 through 2025. We tested three strike selections: at-the-money (ATM), 2% out-of-the-money (OTM), and 5% OTM. Each month, we sold the nearest monthly expiration call one day after the previous expiration.

SPY Results: ATM Covered Calls

The ATM covered call returned 7.2% annualized versus 12.8% for SPY buy-and-hold. Yes, the covered call strategy underperformed buy-and-hold by 5.6% annually despite collecting substantial premium. The reason: whenever SPY rallied more than a few percent in a month, the gains were capped. In a market that tends to go up, capping upside is expensive.

SPY Results: 2% OTM Covered Calls

The 2% OTM strategy returned 9.8% annualized, better than ATM but still trailing buy-and-hold by 3%. This strike allowed participation in small up moves while still collecting meaningful premium. The maximum monthly gain was capped at approximately 3.5% (2% appreciation plus 1.5% premium).

SPY Results: 5% OTM Covered Calls

The 5% OTM strategy returned 11.4% annualized, nearly matching buy-and-hold. However, the premium collected was minimal (0.3-0.5% monthly), and the strategy only differentiated itself during large rallies that exceeded 5% monthly, which occurred approximately 8% of the time.

The Volatility Drag Benefit

Where covered calls genuinely helped was in reducing portfolio volatility. The ATM strategy had a standard deviation of 8.1% versus 14.2% for buy-and-hold. The Sharpe ratio of the 2% OTM strategy (0.72) actually exceeded buy-and-hold (0.62), suggesting the strategy has merit for risk-adjusted returns if not absolute returns.

Individual Stock Results

We tested covered calls on 20 large-cap stocks. Results varied dramatically. Low-volatility stocks like JNJ and PG showed covered calls nearly matching buy-and-hold returns. High-growth stocks like AAPL and NVDA showed covered calls massively underperforming because the stocks frequently gapped above the strike on earnings or momentum.

The Earnings Problem

Stocks that reported earnings during the option period created a dilemma. Premium was highest before earnings (great for sellers) but the risk of assignment after a gap up was also highest. Our backtest shows that avoiding covered calls during earnings months improved returns by 1.8% annually on individual stocks.

Tax Implications

Covered calls create complex tax situations. Calls exercised in under 12 months convert long-term holdings into short-term gains. Premium received is always short-term gain. Our after-tax backtest showed covered calls underperforming by an additional 1.5% annually in taxable accounts due to tax efficiency loss.

When Covered Calls Make Sense

The backtest supports covered calls in specific scenarios: on stocks you intend to sell soon anyway (the strike is your target price), in sideways markets where you expect range-bound action, and in retirement accounts where the income is desired and tax consequences are irrelevant.

The Bottom Line

Covered calls are not free income. They represent a trade of upside participation for premium income and reduced volatility. In trending markets that characterize most of stock market history, this trade-off is negative for total returns. For investors who genuinely prefer income and lower volatility over maximum growth, the 2% OTM monthly strategy offers a reasonable compromise backed by our backtest data.