Mental Accounting: A New Behavioral Explanation of Covered Call Performance

The empirical performance of covered call writing is quite puzzling in the traditional finance framework. Covered call writing is typically a risk reducing strategy so its expected return should be less than the expected return on the underlying in an efficient market. However, recent empirical evidence suggests (covering a period from 1988 onwards) that the covered call writing has nearly the same return as the underlying whereas the standard deviation of returns is considerably less. Market professionals consider a call option to be a surrogate for the underlying. Such mental accounting of a call option with the underlying has strong support in laboratory experiments. We show that such mental accounting embodied in the principle, assets with similar payoffs must have the same expected returns, provides a new behavioral explanation for the puzzling empirical performance of covered call writing.