Lower Risk Higher Return: Selling 0DTE SPY Covered Calls

SPY Tuesday and Thursday options became available on November 14, 2022. Thus, SPY has options that expire on every trading day. This revolutionized the practice of selling covered calls. Selling a 0DTE SPY covered call is similar to selling a regular covered call, except that you sell a call option that expires on the same day as you sell it. For example, if today is Monday, you would sell a call option that expires on Monday. This means that you have less time for the stock price to move against you, and you can collect more premium per unit of time.

The main benefit of selling a 0DTE SPY covered call is that you can generate income from your stock portfolio in a short period of time. You can repeat this strategy every trading day, as long as there are options available for SPY. This can add up to a significant amount of income over time, especially if you reinvest the premium into more shares of SPY.

The Covered Call Algorithm

We are applying historical data to design a strategy for selling 0DTE SPY covered calls. To make the process easier, the algorithm follows these steps:

Day 1: Sell a covered call:

Time: just before the market closes

Expiration: the next trading day

Strike: slightly OTM, or the 1st strike above the closing price. For example, if the closing price is $395.34, the strike will be $396

Day 2: Roll the covered call:

If the covered call is OTM, repeat Day 1.

If the covered call is slightly ITM, or just a few dollars away from the underlying, keep the strike and roll out the covered call to the next trading day.

If the covered call is deeply ITM, or far away from the underlying, roll out and up the covered call. That is, let the covered call be exercised and buy stock and sell another covered call. This is equivalent to buying back the deeply ITM covered call and selling another covered call like Day 1.

Day 3: Repeat Day 2.

 The Result

A covered call contract gives the buyer the option to buy 100 SPY shares at a fixed price. For simplicity, we use a single share to compare how SPY performs and do not count commissions and fees.

Since the start of this strategy, selling daily SPY 0DTE call options against the underlying ETF has outperformed the benchmark by 3.95 percent. The strategy also reduced the volatility and the maximum drawdown by more than half compared to holding SPY alone. The risk-return ratio, measured by Sharpe ratio, is 1.28 for the covered call strategy, while it is only 0.56 for SPY. This means that the strategy can protect the downside risk when the market drops, but also capture some of the upside potential when the market rises. Over a year, this strategy generated a beta of 0.50 and an alpha of 7.4% for the SPY covered call portfolio, meaning that it had only half of the benchmark volatility but made significant excess return over the benchmark.

Conclusion 

A covered call is a technique that allows stock investors to earn additional income from their holdings while limiting their downside exposure. However, it also means sacrificing some of the potential gains. By using 0DTE options, investors can collect more premiums from selling calls. Covered call can improve the performance and reduce the volatility of a stock portfolio if done properly. Before applying this technique, investors should learn how covered calls operate and what are the advantages and disadvantages of using them.