Double Your Gains From a Buy-Write Strategy? Not Exactly

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Double Your Gains From a Buy-Write Strategy? Not Exactly

In his article on covered calls, Kurtis Hemmerling explains a strategy for selling deep in the money call options against a long position in a stock.

The advantage to selling calls, of course, is the option premium you collect in exchange for being willing to part with your stock at the strike price of the option you sold. The disadvantage is that you sacrifice potential upside gains. Whatís more, the premium you collect may not necessarily protect you if the stock you buy plunges.  And remember that while selling calls can provide extra inconme in the form of option premium, there are additional commissions you pay for option transactions.

So is this a good strategy? Well that depends on the stocks you buy and the options you sell. However, Kurtis suggests that in general, it may be an attractive strategy based on the CBOE S&P 500 BuyWrite Index.

This CBOE index is designed to measure the performance of buying S&P 500 stocks and simultaneously selling a just out of the money call option that expires in about a month. According to Kurtis:

In fact, even writing monthly covered calls on the S&P 500 index as tracked by the BuyWrite Monthly Index by the CBOE has outperformed the S&P 500 by more than double the net gains since January 2005 until today.

Double the net gains? Not so fast. Letís take a closer look at this index.

Selecting the right benchmark

Hereís a chart showing the CBOE S&P 500 BuyWrite Index (BXM) against the S&P 500 since January 2005.

Looks like a big outperformer, doesnít it ñ with the BXM index up about 20.9% while the S&P 500 index is only up by about 5.8%.


But a closer look at how the CBOE calculates the index (PDF) shows that dividend and option premium income accumulate in the index value:

The BXM Index provides a benchmark measure of the total return performance of this hypothetical portfolio. Dividends paid on the component stocks underlying the S&P 500 Index and the dollar value of option premium deemed received from the sold call options are functionally ìre-investedî in the covered S&P 500 Index portfolio. The BXM Index is based on the cumulative gross rate of return of the covered S&P 500 Index portfolio since the inception of the BXM Index on June 30, 1986, when it was set to an initial value of 92.211.

So if the BXM index functionally ìre-investsî dividend and option income, comparing it against the S&P 500 index isnít using the right benchmark.

A more appropriate comparison would be to compare the BuyWrite index against owning the S&P stocks themselves, say in the form of owning the SPDR S&P 500 ETF (SPY), where performance includes both potential stock gains and dividends.

This chart shows how the index has performed against both the S&P 500 index and the SPY ETF.



As you can see, the BXM index has an edge over SPY. Over the past six years, the BXM index is up about 20.9% compared to an increase of about 18.5% for SPY. Thatís a significant difference, of course, but not nearly as significant when comparing BXM to the S&P 500 index level itself.

Less risk?

Does the buy-write strategy reduce risk? That depends how you define risk. Yes, the buy-write strategy seems to hold up better when stocks are falling or drifting sideways and it could reduce portfolio volatility.

Remember that while selling calls can provide extra in the form of option premium, your stock can be called from you at any time before expiration ñ and you donít collect any dividends.

And that premium income may not provide all that much of a cushion when stocks plunge. Just look at what happened to the BXM index during the crash in late 2008. Any ìcushionî reminds me of that thin mat underneath the parallel bars in gym class.  If you fall, you may not be seriously injured, but it still hurts.

This chart compares weekly returns of the S&P 500 index against the BXM BuyWrite Index over the past three years.



The slope of the line (about 0.70) could be viewed as the indexís ìbeta.î Just as a comparison, Alcoa (AA) has a beta of about 2.14 while AT&T (T) has a beta of about 0.62.

Other buy write indices

The CBOE also maintains buy-write indices for other groups of stocks. Hereís a look at the CBOE DJIA BuyWrite Index (BXD) compared to the SPDR Dow ETF (DIA).



And hereís the CBOE NASDAQ-100 BuyWrite Index (BXN) compared to the PowerShares QQQ ETF (QQQQ)



Note that the NASDAQ-100 doesnít include many higher dividend stocks so the performance of the actual index is a lot closer to the QQQQ ETF that tracks it.

And for disclosure purposes, hereís standardized data on the three ETFs mentioned in this post:


For the individual stocks that Kurtis used as examples in his articles, the call selling strategies he suggests may make sense ñ and a call selling strategy may be a way to reduce portfolio volatility. Of course that depends which strikes and expirations you sell, and whether you buy the ìwriteî stocks (sorry, couldnít resist), a subject Iíll cover in a future post.
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