Blog - Investing Notes

December 24, 2008 - Testing A Simple Index Covered Calls Strategy (Revised 12/26/08 Based on Reader Comments)

Does iteratively selling short-term, slightly out-of-the-money covered calls on a broad stock index position reliably outperform buying and holding the index? We can explore the answer to this question by applying assumptions about trading frictions to the CBOE S&P 500 BuyWrite Index (BXM), a benchmark index designed to track the performance of a hypothetical buy-write strategy on the S&P 500 Index. Using monthly (options expiration date) data for BXM and the S&P 500 index spanning 7/19/86 through 12/19/08 (270 months), we find that...

CBOE describes the BXM index as follows:

"Announced in April 2002, ...[d]ata on [hypothetical] daily BXM prices now is available from June 30, 1986, to the present time... The BXM is a passive total return index based on (1) buying an S&P 500 stock index [SPX] portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index "covered" call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written."

The "cash settled" process for options that expire in-the-money, per "Description of the CBOE S&P 500 BuyWrite Index", is based on the actual difference between the S&P 500 index and the option strike price. CBOE also explicitly qualifies returns for the BXM index via the following disclaimer:

"The BXM Index is designed to represent a proposed hypothetical buy-write strategy. Like many passive indexes, the BXM Index does not take into account significant factors such as transaction costs and taxes and, because of factors such as these, many or most investors should be expected to underperform passive indexes. Transaction costs for a buy-write strategy such as the BXM could be significantly higher than transaction costs for a passive strategy of buying-and-holding stocks."

To bring the hypothetical closer to reality we make the following assumptions:

• The covered call portfolio bears a monthly transaction fee of 0.01% to 0.1% of portfolio value to sell call options. Actual fee percentages would depend on actual broker fees and the size of the portfolio.
• The BXM index takes into account the options bid-ask spread for position entries by using the average of actual sale prices of the selected option series during a specified short interval. This approach is probably optimistic since the underlying strategy is always selling, but we accept it for this analysis.
• Call options expire worthless (no exit fee) if the S&P 500 index at the close on a given options expiration date has risen by 0.3% or less from the close on the last options expiration date. The actual threshold for out-of-the-money expiration would depend on actual option strike prices and associated expiration date closing levels of the S&P 500 index.
• The covered call portfolio bears a transaction fee of 0.01% to 0.1% to exit each options position that reaches expiration in the money, assuming cash settlement of the difference between the index level and the strike price, as noted above. Actual trading friction percentages would depend on actual broker fees and the size of the portfolio.

The following chart shows the cumulative return since July 1986 for: the S&P 500 index, the BXM index as calculated by CBOE and the BXM index as adjusted by these assumptions (specifically the worst case monthly entry friction of 0.1% and an as-required worst case exit friction of 0.1%). As modeled, the S&P 500 index call options expire in-the-money about 58% of the time. Both the frictionless BXM and the BXM with trading friction mostly outperforms the S&P 500 index.

How sensitive are net returns to variation in trading frictions?

The next chart compares average monthly (options expiration date to options expiration date) returns and standard deviations of monthly returns for the S&P 500 index and BXM across a range of BXM trading frictions. For each BXM scenario, the first percentage is the monthly percentage trading friction for selling call options, and the second percentage is the trading friction for settling those options positions that expire in the money. The average monthly returns for all trading friction scenarios beat or exceed the average monthly returns for buying and holding the S&P 500 index. All covered call strategies have substantially lower volatilities than does an S&P 500 index buy-and-hold approach.

In summary, a rolling covered call strategy on a broad market index suppresses portfolio volatility and may well outperform based on average monthly returns. Access to low trading costs and cash settlement of in-the-money expirations is key to outperformance.

For related research, see Blog Synthesis: Equity Options.