Let's Talk About Buy-Writes - Analyzing the Performance

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...continued from Let's Talk About Buy-Writes: Automation, Advisers & BXM

Weíve already explored the basics of buy-writes (Introduction) as well as some interesting buy-write products that are currently available in the marketplace(Automation, Advisers & the BXM ). However, weíve only begun to scratch the surface of this burgeoning sector of the options market.

Thankfully, several new studies have gone a long way toward improving our understanding of the buy-write strategy and its many applications.


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THE OIC/CISDM STUDY
The first study was sponsored by the Options Industry Council (OIC) and conducted by the Center for International Securities and Derivatives Markets (CISDM) at UMASS (click here to read the full study). Unlike earlier studies, the OIC/CISDM study goes beyond the traditional S&P 500 stomping ground and explores Russell 2000 buy-write performance.

Just as the CBOE/Ibbotson study in 2004 went a long way toward legitimizing the value of the fledgling BXM in the eyes of many investors, the OIC/CISDM study may eventually pave the way for a new wave of Russel 2000 buy-write products.

THE METHODOLOGY
As discussed in our earlier buy-write articles, there are many different variables involved in a buy-write. As a result, any study of buy-write performance has to accurately account for various elements such as time decay, time to expiration, capital appreciation, etc.

In order to minimize the impact of these variables, the OIC/CISDM study limited their analysis to 2% out-of-the-money (OTM) calls and at-the-money (ATM) calls.

THE RESULTS
Over the ten years from 1996 to 2006, the Russell 2000 achieved an annualized return of 10.67%. During that same period, the 2% OTM buy-write approach had a 10.6% return and the ATM strategy returned 9.21%.

At this point, youíre probably asking yourself why anyone would go through the hassle of executing a buy-write just to achieve similar or worse returns than the index itself. The answer to that question lies in that ever-present boogeyman of the options markets ñ volatility.

SLAYING THE BOOGEYMAN
The returns of the two Russell buy-write strategies may not appear impressive at first glance, especially when compared to the overall returns of the index itself.

However, potential investors need to keep in mind that the Russell index achieved its return with an annualized volatility of 20.52%. The OTM and ATM buy-write strategies achieved similar returns with only 14.85% and 13.36% volatility respectively. Achieving roughly equal returns with anywhere from one-quarter to one-third less risk is impressive in anyoneís book.

BEATING THE BULL
One prominent stumbling block for buy-writes has always been the belief that they under-perform during bull markets. The genesis of this belief is the fact that writing calls against equity positions tends to limit the amount of capital appreciation that an investor can realize.

In order to fully explore this belief, the OIC/CISDM study broke their results down into sub-groups. These sub-groups allowed them to further analyze the performance of buy-write strategies during bull market periods.

Analysis of these sub-groups found that, even during bull market periods, the Russell 2000 buy-write strategies out-performed the index on a risk-adjusted basis. This surprising result may finally put to rest the long-standing belief that trading buy-writes during bull markets is a ticket to poor returns.

CBOE/FEG STUDY
The OIC/CISDM study is not the only new study to plumb the depths of buy-write performance. The CBOE, a pioneer in the buy-write market, has also released a new study in conjunction with the Fund Evaluation Group (FEG) (click here to review the full results of the study).

However, instead of analyzing the BXM, the CBOE/FEG study analyzes the  performance of the CBOE Dow Jones Industrial Average BuyWrite Index (BXD) and CBOE Dow Jones Industrial Average Volatility Index (VXD).

The CBOE/FEG study utilized a nine-year time span to analyze the performance of these products. Like the OIC/CISDM study, this study also found that buy-writes generate similar rates of return to the underlying with reduced levels of volatility.

DIVERSIFICATION
One interesting aspect of the CBOE/FEG study, though, is its approach to diversification. This study evaluated the impact of allocating 25% of an all-stock portfolio to the BXD. The results showed that this diversification would lower the portfolioís overall volatility by about 9% over the nine-year period.

The allocation required to significantly reduce volatility with the VXD was even smaller. The study found that a 10% allocation of an all-stock portfolio to the VXD could reduce overall volatility by roughly 26%. Perhaps even more interesting, both of these volatility reductions were achieved without significantly affecting the returns of the all-stock portfolio.

THE CONCLUSIONS
Hopefully, both of these studies will go a long way toward eliminating the doubts that many investors, financial planners and asset managers have about buy-writes. Thanks to the efforts of the CBOE & OIC, we now have  multiple buy-write studies that explore different approaches on different indices. The fact that all of these studies have reached the same conclusion (buy-writes can improve the risk-adjusted returns of your portfolio)is a powerful endorsement of the efficacy of this strategy.

Of course, more research still needs to be done. Most of these studies utilized fixed methods for choosing which call to write against the underlying (e.g.- 2% OTM calls or ATM calls). However, there has yet to be any significant research into the impact of varying a buy-write strategy depending on market conditions (e.g.- writing ATM calls during bear markets then switching to OTM calls during bull markets, etc.). Since many traders mistrust the rigid approach of automated buy-write products, a study with a variable approach may go a long way toward bringing these skeptics into the buy-write fold.

THE FUTURE
At the end of the day, these two studies will definitely promote interest in this area of themarket and perhaps kick-start the development of new buy-write products. It is difficult to argue with those results.

In any event, it is promising to see more research being conducted in this area. The buy-write market has enormous potential. If these studies can help to spread the gospel of writing calls against stock, then they will have done their jobs admirably.
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