Covered Call Writing in a Cumulative Prospect Theory Framework

Abstract

The covered call writing, which entails selling a call option on one’s underlying stock holdings, is perceived by investors as a strategy with limited risk. It is a very popular strategy used by individual, professional and institutional investors; moreover, the CBOE developed the Buy Write Index which tracks the performance of a synthetic covered call strategy on the S&P500 Index. Previous studies analyze behavioral aspects of the covered call strategy, indicating that hedonic framing and risk aversion may explain the preference of such a strategy with respect to other designs. In this contribution, following this line of research, we extend the analysis and apply Cumulative Prospect Theory in its continuous version to the evaluation of the covered call strategy and study the effects of alternative framing.

Keywords: Behavioral Finance, Cumulative Prospect Theory, Hedonic Framing, Options Trading Strategies

JEL Classification: C63, D81, G13