Finding Alpha via Covered Index Writing

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Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 Index over thepast 15+ years while realizing lower standard deviations of returns. This analysis dissects thestrategy underlying the BuyWrite Monthly Index on the S&P 500. The BXM is the most broadlyquoted benchmark for index callselling strategies. Also discussed are alternative structured S&P500 optionoverwriting strategies, which have even more attractive riskreturn trade-offs than theBXM because they take advantage of the implicit positive risk premium of equities and potentiallyadjust the strike price of the call sold on the basis of the volatility environment.

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  • September/October 2006 www.cfapubs.org 29

    Financial Analysts JournalVolume 62 Number 5

    2006, Goldman, Sachs & Co.

    Finding Alpha via Covered Index WritingJoanne M. Hill, Venkatesh Balasubramanian, Krag (Buzz) Gregory, and Ingrid Tierens, CFA

    Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 Index over thepast 15+ years while realizing lower standard deviations of returns. This analysis dissects thestrategy underlying the BuyWrite Monthly Index on the S&P 500. The BXM is the most broadlyquoted benchmark for index callselling strategies. Also discussed are alternative structured S&P500 optionoverwriting strategies, which have even more attractive riskreturn trade-offs than theBXM because they take advantage of the implicit positive risk premium of equities and potentiallyadjust the strike price of the call sold on the basis of the volatility environment.

    he new S&P 500 BuyWrite Index (BXM) ofthe Chicago Board Options Exchange(CBOE) has outperformed the S&P 500Index with only two-thirds of its risk.

    Whats the catch? Well, for one thing, a user of theBXM needs to be willing to accept some underper-formance in spectacularly strong equity marketswhen everyone else is bragging about their hotstock picks. The relatively boring strategy to cap-ture the BXM returns consists of going long S&P 500exposure while shorting at-the-money (ATM) calloptions on the S&P 500. It does best relative to theindex when equity markets are quiet, posting mod-erate or falling returns, and is, therefore, worthstudying further in the current environment.

    Academics and investment consultants havestudied the BXM in terms of its return and riskcharacteristics both alone and in combination withother asset classes.1 In the period we studied (1January 1990 to 31 October 2005), the BXMs annu-alized return of 11.0 percent was about 60 bps abovethat of the S&P 500, with a standard deviation of lessthan 10 percent (compared with about 14.5 percentfor the S&P 500). Although some of the lower risk interms of standard deviation came from eliminatingupside swings in rising markets, as Figure 1 andFigure 2 show, the track record has been impressivein both bull and bear markets.

    Some of the best returns of the BXM relative tothe S&P 500 have been in low-volatility periods like

    that of the early 1990s and in the bear market of20002002. In some sustained periods, such as19951998, the BXM underperformed the S&P 500by more than 5 percentage points each year.

    Recently, with investors attracted by the returnand risk characteristics, as well as regular cashflows, of the BXM, several funds and structuredproducts have been created to track the index.2

    With the recent introduction of options on the S&P500 SPDR (S&P Depositary Receipts) exchange-traded funds (SPY), these strategies can also be usedfor covered call writing on the SPY. The BXM canalso serve as a benchmark for more active or alter-natively structured options strategies designed tooutperform the index.

    We analyze the strategy underlying the BXMand some alternative structured index optionoverwriting strategies that have even more attrac-tive riskreturn trade-offs than the BXM, includingfixed-strike overwriting strategies and a flexiblestrategy that dynamically adjusts the strike basedon the volatility environment.

    Factors Driving the Performance of a Covered Call StrategyBefore jumping into the specifics of the BXM andalternative overwriting strategies, we remind read-ers of the factors that drive the performance of thesestrategies. We have identified the following driversof overwriting strategy returns:3

    1. The fair call premium: the premium that wouldgo to the call seller who had perfect volatilityforesight in a world with no trading costs; thatis, the call is priced at the volatility realized overthe life of the option, rather than at impliedvolatility, and there is no bidask spread.

    Joanne M. Hill is managing director at Goldman, Sachs& Co., New York City. Venkatesh Balasubramanian isan associate at Goldman, Sachs & Co., New York City.Krag (Buzz) Gregory and Ingrid Tierens, CFA, are vicepresidents at Goldman, Sachs & Co., New York City.

    T

  • Financial Analysts Journal

    30 www.cfapubs.org 2006, Goldman, Sachs & Co.

    Figure 1. Cumulative Total Return on the BXM and S&P 500, 1 January 1990to 31 October 2005

    Sources: CBOE and Standard & Poors.

    Figure 2. Annual Total Return on the BXM and S&P 500, 1 January 1990 to 31 October 2005

    Sources: CBOE and Standard & Poors.

    31 December 1989 = 100

    S&P 500

    BXM

    550

    500

    450

    400

    350

    300

    250

    200

    150

    100

    5089 0593 97 01 0391 95 99

    Annual Return %

    40

    30

    20

    10

    0

    10

    20

    3094 98 029690 92 00 04 05

    S&P 500 BXM

  • Finding Alpha via Covered Index Writing

    September/October 2006 www.cfapubs.org 31

    2. The volatility premium: the premium that cap-tures the impact of selling options at impliedvolatility instead of at the volatility realizedover the life of the option.

    3. The exercise cost: the component of the call pre-mium that reflects the market impact of execut-ing the sale. The bidoffer spread is the basisfor this cost unless the transaction size is largeenough to move the price.

    4. The trading cost: the loss in call premium as aresult of the bidask spread.As we demonstrate later, Items 13 are the

    most important contributors to performance. Dis-cussions of covered indexselling strategies areusually restricted, however, to Items 1 and 2: theability to collect a steady premium that enhancesperformance and the opportunity to capture aspread of implied volatility over realized volatility,which has been mostly positive at the index level.Because of the general emphasis on these twoissues, we provide more details about them beforewe discuss the significance of the third importantpoint, exercise cost.

    Call Option Premium Levels. An attractivefeature of call-overwriting strategies is that the callsold generates a monthly cash flow much like inter-est or dividends. However, these cash flows haveimportant differences in regard to how they are col-lected. First, the option premium reflects the proba-bility that the seller will incur a loss through exercise

    of the option by the buyer at expiration. Second, taxconsiderations need to be taken into account. In theUnited States, for example, the call premium is tax-able as a capital gain, which for most U.S.-basedinvestors is taxed at a higher rate than dividends.4

    Figure 3 shows the level of one-month S&P 500call premiums historically for ATM options and foroptions 2 percent and 5 percent out of the money.5

    The premiums for these options averaged, respec-tively, 2.1 percent, 1.1 percent, and 0.4 percent overthe past 15+ years. The variation over time is pri-marily a result of shifts in volatility reflected inoption prices, but premiums also move higher withthe level of interest rates relative to S&P 500 divi-dend yields. Note that these premiums haverecently been at the lower end of their range becauseboth volatility and short-term interest rates havebeen at lower levels (and with improved corporatecash levels and more favorable dividend tax treat-ment, dividend yields have been shifting higher).

    The Volatility Connection. Another reasonindex-overwriting strategies have such attractivereturn properties is that they capitalize on inves-tors and traders fears of a financial disaster.Options contain a premium for the volatility envi-ronment expected to prevail during the life of theoption. This premium reflects the risk of having alarge move that would cause a loss to the optionseller. Ever since the crash in October 1987, thevolatility implied in S&P 500 options, especially

    Figure 3. One-Month S&P 500 Call Option Premiums for Various Strikes, 1 January 1990 to 31 October 2005

    Source: Goldman Sachs.

    Option Premium (% of spot)

    5

    3

    4

    2

    1

    089 0593 97 01 0391 95 99

    ATM Call 2% OTM Call 5% OTM Call

  • Financial Analysts Journal

    32 www.cfapubs.org 2006, Goldman, Sachs & Co.

    those with strike prices at or below the index, hascontained a premium for crash or downsidegap riskthe risk that all stocks will fall togetherin jumps so that trading out of positions will bedifficult.

    Figure 4 shows the implied volatility of ATMone-month S&P 500 index options back to 1990.Only in the highest-volatility regimes has realizedvolatility moved higher than the volatility impliedin option prices. The average spread between one-month implied and realized volatility has been 2.4percentage points for 1990 through October 2005.As Figure 5 shows, however, many times during thebear market conditions of 20002002, the actualmarket risk experienced was higher than that pricedinto the S&P 500 options.

    The existence of differences between theimplied volatility of S&P 500 options among strikeprices is referred to as the skew. As shown inFigure 4, implied volatility for ATM options is nor-mally higher than realized volatility for the S&P 500.The spread of implied-to-realized volatility, how-ever, is wider for OTM put options than for OTMcall options. For example, over the period January1990 through October 2005, the implied volatility ofthe 2 percent S&P 500 OTM put options averaged3.9 percentage points above realized volatility. In

    contrast, the implied volatility of the 2 percent S&P500 OTM call options averaged 1.5 percentagepoints above that of realized one-month volatility.

    The existence of the skew has two, relatedexplanations that imply hig

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