Are there predictable times when selling covered call options outperforms selling cash-covered put options? In his March 2010 paper entitled “Buy-Write or Put-Write, An Active Portfolio to Strike it Right” (the National Association of Active Investment Managers’ 2010 Wagner Award runner-up), George Yang investigates using trend signals to trigger switching between covered call and put writing. The test portfolio consists of: (1) a long position in the S&P 500 Total Return Index (SPTR); (2) cash (Treasury bills); and, (3) a short position equivalent to the value of (1) plus (2) in at-the-money, next-month call or put options on the S&P 500 Index. The Golden Cross/Black Cross Rule (the 50-day simple moving average crossing above/below the 200-day simple moving average) applied to SPTR triggers switches between calls (after black crosses) and puts (after golden crosses). Using daily closes for SPTR, the S&P 500 Buy-Write Index (BXM) and the S&P 500 Put-Write Index (PUT) during June 1988 through December 2009 (21.6 years), he finds that:
- For a 50%-50% SPTR-cash allocation, rebalanced on Golden/Black Cross signals, the strategy of switching between selling covered calls and puts generates a gross annualized return of 16.3% and a Sharpe ratio of 0.95 over the sample period, outperforming component strategies (see the table below).
- With no trading friction, $1.00 invested in the strategy on 6/1/88 reaches a value of $26.22 on 12/31/09, compared to $6.77, $7.66 and $9.73 respectively for buying and holding SPTR, BXM and PUT.
- Over the sample period, the strategy’s Golden/Black Cross signals trigger only 18 option trades beyond the monthly roll-overs specified for BXM and PUT, suggesting that the strategy outperforms its components even after conservatively estimated trading friction.
- However, the strategy may underperform component strategies during precipitous market declines, such as those in the summer of 1998 and the fall of 2008. More frequent rollover of short call or put positions to at-the-money (or out-of-money) may mitigate this shortcoming.
- Regarding SPTR allocations other than 50%-50%, for the sample period used:
- A strategy that flips between 57.5%-42.5% SPTR-cash after Golden Cross signals and 42.5%-57.5% after Black Cross signals optimizes risk-adjusted return.
- A strategy that flips between 80%-20% SPTR-cash after Golden Cross signals and 20%-80% after Black Cross signals boosts gross annualized return from 16.3% (for a 50%-50% allocation) to 19.3%.
The following table, taken from the paper, compares gross performance statistics over the sample period for the strategy of switching between selling covered calls and puts based on a 50%-50% SPTR-cash allocation [SPTR GCBC-ALOOP (f=0.5)] with those for:
- Buying and holding SPTR
- Buying and holding BXM
- Buying and holding PUT
- Going long SPTR at each Golden Cross and to Treasury bills at each Black Cross [SPTR GC-LEO]
In general, the tested strategy generates attractive gross annualized return, Sharpe ratio, Sortino ratio, beta, USharpe ratio (Sharpe ratio measured only for downside volatility) and maximum drawdown compared to its component strategies.
In summary, investors may be able to use simple trend-following rules to enhance returns from a strategy designed to capture a combination of the equity risk premium from stocks and the volatility risk premium from short options.
Note that optimism in assumptions about trading frictions for BXM and PUT may be material (see the last paragraph in “Moneyness and the Profitability of Shorting Equity Options”) and that trading friction is generally larger for small portfolios than large ones.
On 6/25/10, study author George Yang provided a correction regarding SPTR-cash allocations other than 50%-50% (incorporated above) and the following additional comments:
“I fully agree with your emphasis on the significance of considering the trading frictions for this type of strategy. Furthermore, market impact could also be very important. Two sources of unfavorable market volatilities on key dates are: (1) buying or selling SPTR on trend signal change days (for allocations other than 50%-50% SPTR-cash); and, (2) cash settling of a large number of in-the-money call or put contracts on option expiration Fridays.
“On the surface, selling index options at leveraged levels all the time could depress the volatility risk premium and even wipe out the strategy’s profitability over the long term. However, market trend could play an important role in preserving a volatility premium. During an uptrend, the index put-call ratio is decreasing. The demand for long calls by other market participants (in excess of the puts the strategy is selling) reduces the need for option market makers to short the index or futures for hedging, thereby depressing uptrend realized index volatility. During a downtrend, the opposite could happen to maintain the premium of implied volatility over realized volatility over the long run.”
