OIC Study: Buy-Write Returns Exceed Indices

Terry Flanagan

The Options Industry Council announced the results of a study showing that using a buy-write strategy on the Russel 2000 index during the 15 years prior to March 2011 resulted in higher returns than buying and holding the index and, perhaps more importantly, less risk.

The study showed that over the 182-month period, the 2% out-of-the-money buy-write returned 263%, or 8.87% annually, compared to the Russel 2000’s annual return of 8.11%. Over that entire period, the annualized standard deviation for the buy-write portfolio was 16.57%, or nearly 4.5 percentage points lower than for the Russell 2000 portfolio, resulting in a significant risk reduction.

The buy-write strategy employs covered calls, in which an investor sells a call option on a security he or she owns. In the study, calls were hypothetically sold at 2% above the current value of the index, providing that increase in value and the option premium as the maximum return. The strategy requires writing new call options on the index every month.

The buy-write strategy’s performance in the study came as little surprise to Richard Cancelmo, who manages Bridgeway Capital Management’s Managed Volatility Fund and heads up the investment management firm’s trading team. He noted that the managed volatility fund sells covered calls and secured puts, and the fund has beaten the S&P 500 since its inception 10 years ago. The return of the fund through June 30 was 3.59% compared to 2.72% for the S&P 500.

“This was done with significantly less risk as measured by beta,” Cancelmo said, adding the fund was 60% less risky than the S&P 500.

The Chicago Board Options Exchange’s CBOE S&P 500 BuyWrite Index, or BXM, is the granddaddy of buy-write indices. Ronald Egalka, whose Rampart Investment Management was the first firm to license the strategy from Standard & Poor’s and the CBOE, said that in the 15 years prior to Aug. 31 the BXM provided an annualized return of 6.38%, while the total return for the S&P 500 index was 6.12%. “The standard deviation of return for the BXM was 12.09%, and for the S&P it was 16.43%, said Egalka, noting the BXM provided 26 basis points more in annualized return with three quarters the risk.

Rampart manages $1.3 billion in money from a variety of investors using option strategies, some designed to track indices such as the BXM and the BXY, which offers a 2% out-of-the-money strategy similar to the study’s. Other strategies are employed to provide incremental income on concentrated positions and/or defensive strategies to protect individual positions or portfolios.

Egalka said the BXM uses “at-the-money” calls, which in fact are written at the first strike price out of the money. Those call options offer higher premiums but less upside.

“In stronger markets, the 2% out-of-the-money strategy will give you a better total return, because you have more upside potential,” Egalka said, adding, “In flat markets you don’t do as well, because there’s no upside benefit and you’re only getting a portion of the premium flow that you would get at the money.”

The study, conducted by Edward Szado, a research associate at OIC, and Nikunj, an associate professor at the University of Massachusett’s Isenberg School of Management, also analyzed performance in three sub-periods.

The buy-write strategy tends to be less effective during bull markets, since once calls are exercised the option holder must sell the stock and misses additional upside. And in fact, during the bull market between March 2003 and October 2007, the study’s buy-write strategy returned 19.63% compared to the Russell 2000’s return of 20.92%. However, the annualized volatility of the buy-write strategy was only 10.52% compared to the stock index’s 14.08%.

“In other words, the buy-write strategy achieved almost the same return as the index at about two-thirds the index volatility,” the authors of the study note.

During the credit crisis, from November 2007 through March 2011, the study’s buy-write strategy had an annualized gain of 2.2%, or only about 21 basis points above the Russell 2000’s return of 1.99%. However, the option strategy’s return was achieved at four fifth the risk of buying and holding the index.

The third period tested was between the start of February 1996 through February 2003, a period the study authors describe as “somewhat favorable” for applying the buy-write strategy, especially in the second half when the Russell 2000 trended downward. During the overall period, the study found the buy-write generated nearly twice the return of the Russell 2000, at 5.49% compared to 3.28%, at about three quarters of the volatility.

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