Finding Alpha via Covered Index Writing

Joanne M. Hill, Venkatesh Balasubramanian, Krag (Buzz) Gregory and Ingrid Tierens

Financial Analysts Journal, 2006, vol. 62, issue 5, 29-46

Abstract: Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 Index over the past 15+ years while realizing lower standard deviations of returns. This analysis dissects the strategy underlying the BuyWrite Monthly Index on the S&P 500. The BXM is the most broadly quoted benchmark for index call–selling strategies. Also discussed are alternative structured S&P 500 option–overwriting strategies, which have even more attractive risk–return trade-offs than the BXM because they take advantage of the implicit positive risk premium of equities and potentially adjust the strike price of the call sold on the basis of the volatility environment.Covered S&P 500 Index call strategies have, on average, outperformed the S&P 500 total return index over the past 15+ years while realizing lower total risk (as measured by standard deviation of returns). The most broadly quoted benchmark for index call–selling strategies is the BXM, a return-based buy-write index on the S&P 500 Index introduced by the Chicago Board Options Exchange in 2002. We dissect the strategy underlying the BXM and consider its returns in the 1990–2005 period. We find it has outperformed the S&P 500 with only two-thirds of the risk of the S&P 500. Even though some of the lowered risk came from eliminating upside swings in rising markets, its track record has been impressive.We propose and analyze some alternative structured S&P 500 option–overwriting strategies that have even more attractive risk–return trade-offs than the BXM because they take advantage of the implicit positive risk premium of equities. We first examine the impact of selling out-of-the-money (OTM) calls rather than at-the-money (ATM) calls, which underlie the BXM. Selling 2–5 percent OTM calls combined with a long position in the S&P 500 generated returns that averaged about 2 percentage points a year above the S&P 500 return in 1990–2005. The annualized risk was 1.5–3.5 percentage points below the risk of the S&P 500, and tracking error ranged between 3 percent 6 percent a year.We also analyze more flexible covered index strategies, which dynamically adjust the strike price of the call sold on the basis of the current volatility environment. In our tests, these strategies produced a return–risk profile similar to that of the fixed-strike strategies but with a more stable exercise frequency.

Date: 2006
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DOI: 10.2469/faj.v62.n5.4281

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