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By  Farris G. Shuggi, CFA

Exploiting Durable Inefficiencies in the Equity Options Market

Seeking to capture value from inefficiencies in the equity options market.

June 2025, From the Field

Key Insights
  • Covered call writing presents a differentiated path to attractive risk-adjusted returns potential.
  • We believe that there is often overestimation of future volatility by market participants that creates persistent overcompensation for selling call options. 
  • By using single-name covered call writing on a basket of lower-beta stocks, investors can pursue higher yields while managing downside risks.
View Transcript

In a covered call strategy, the seller of the option is essentially selling the future potential upside, or volatility, in a stock they own, in exchange for payment from the option buyer (also known as the call premium). Covered call writing is a strategy that, when implemented effectively, could help investors enhance a portfolio’s risk-adjusted returns.

With a covered call strategy, an investor owns an underlying stock and writes a call option against that stock. By writing “or selling the call,” an investor agrees to sell the underlying stock at a predetermined price sometime in the future, called the strike price. In exchange, an investor receives a payment from the option buyer for writing the call.

So how can this strategy lead to great risk-adjusted returns over time? 

Our research shows that investors have persistently anticipated higher volatility in the market than what has actually been realized in the future. By overestimating volatility, many investors overpay for the potential protection of owning an option against that future volatility. By selling options, the seller can attempt to profit from the buyer’s overestimation of future volatility in a stock, essentially their fear of missing out on future upside.

When an investor sells these calls against stocks that they own, they sell future volatility and receive payment in the form of call premiums. Those premiums introduce a new source of yield into a portfolio that can complement dividends from underlying stocks and interest from fixed income holdings.

Our research shows that investors have earned the highest risk-adjusted returns by writing calls against low-volatility stocks. While this may result in collecting a lower initial premium, low-volatility stocks have had much lower downside risk relative to high-volatility stocks and thus, over time, have earned much higher risk-adjusted returns.  Overall, we believe introducing a covered call strategy to a traditional portfolio of stocks and bonds can diversify portfolio yield and enhance risk-adjusted returns.  

              

Farris G. Shuggi, CFA Head, Quantitative Equity

Exploiting Durable Inefficiencies in GARP Stocks

By  Farris G. Shuggi

Important Information

Where securities are mentioned, the specific securities identified and described are for informational purposes only and do not represent recommendations.

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

This material is only for investment professionals that are eligible to access the T. Rowe Price Asia Regional Institutional Website. Not for further distribution.

© 2025 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, the Bighorn Sheep design and related indicators (see troweprice.com/ip) are trademarks of T. Rowe Price Group, Inc. All other trademarks are the property of their respective owners.

202508-4702505

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