October 26, 2006

Covered Call Index: How it Compares and
What it Means for Us
by John Brasher, CallWriter Publisher

 

Would you like some hard proof that covered calls work, and work better than stock investing? In May 2002 the Chicago Board Options Exchange (CBOE), America's largest options exchange, created an index designed to track the hypothetical results of a very basic, unsophisticated covered call writing strategy. The CBOE S&P 500 BuyWrite Index (BXM) is a benchmark index that simulates the return one could expect from writing the nearest month covered call on all the stocks in the S&P 500 stock index (SPX), assuming that the nearest out-of-the-money (OTM) call was written every month. The BXM is completely mechanical in nature and designed to test the results of blanket covered-call writing of all S&P 500 stocks compared to simply buying and holding all the S&P 500 stocks. The BXM does not assume that one is buying and writing, or investing in, all the different stocks that comprise the SPX, but instead assumes that one buys the SPX index itself and writes call options on the index. Specifically, the BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) writing the near-term SPX call option, generally on the third Friday of each month. The term "total return" is code for the buy-write covered call strategy. The SPX call written generally 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. Several studies have been done comparing the BXM’s performance to the S&P 500’s buy-and-hold performance, going back to 1989. Every study has reached the same conclusions: The returns from covered call writing were higher than from buying and holding the stocks, and Investment risk was substantially decreased. 2004 Ibbotson Study Ibbotson Associates, a leading provider of asset allocation knowledge and tools, conducted a study in 2004 on the BXM. The study goals were: 1) assess the risk-adjusted performance of the BXM; 2) evaluate the role of this covered-call strategy in a portfolio; and 3) establish if an investor can actually implement the strategy. Ibbotson found that the BXM has had the best risk-adjusted performance of the major domestic and international equity-based indexes over the last 16 years, and that the BXM index enhances the risk-return tradeoff when added to a portfolio. Ibbotson researchers also found that the returns of the Rampart BXM (an investment vehicle that seeks to replicate the index) did closely match those of the CBOE BXM. This is significant because it demonstrates that an investor can implement this covered-call strategy. Here are the specific findings: The compound annual return of the BXM over its 16-year history was 12.4%—slightly higher than the 12.2% achieved by the S&P 500 and with a third less risk. The risk-adjusted return for the BXM buy-write strategy was 38% higher than that of the S&P 500. Based on this historical data, when a 15% allocation of the BXM index was added to a moderate portfolio, volatility was reduced by almost a full percentage point with almost no sacrifice of return. 2006 Callan Study Callan Associates, an investment services consulting firm, published a 2006 study on the BXM, which confirmed the earlier Ibbotson study: The BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk. The compound annual return of the BXM was 11.77% compared to 11.67% for the S&P 500. The risk-adjusted performance, as measured by the monthly Stutzer Index over the 18-year period, was 0.20 for the BXM vs. 0.15 for the S&P 500. A comparison using the monthly Sharpe Ratio yielded similar results (0.22 vs. 0.16, respectively), confirming the relative efficiency of the BXM over the 219-month study period. The BXM underperformed the S&P 500 during most rising equity markets and consistently outperformed the S&P 500 in all periods of declining equity markets, demonstrating the return cushion provided by income from writing the calls. The BXM is entirely artificial, of course. What real stock investors do is pick the stocks they believe will offer the most performance in the future. And what real covered call writers do is pick the best stocks for writing covered calls. Here are two covered call strategies whose results the BXM by its nature does not, and cannot, approximate: portfolio writing and selective buy-writing. The remainder of this article will delve into how they differ from the BXM and why they are superior. Portfolio Writing Benefits Where the BXM assumes buying the entire SPX, real investors only buy stocks they believe in for the medium to long term. The stock investor intends as a general rule to hold only stocks that fit his or her portfolio criteria. They have by definition already performed their analysis and stock selection. What most stock investors don't do is to write calls on portfolio shares, forcing the shares to - in effect - pay a monthly dividend. Portfolio writing ("overwriting") can produce a quite significant income on shares. Suppose you owned a stock that cost you $10. The stock doesn't move much but you believe in it. Assume that for a year it hovers around the $10 mark, moving up and down a buck or more. You could sell the 10 Call on those shares every month for a premium averaging $0.20 or so per share. Some months you would get more, some less. But $0.20 is not an unreasonable average. Twelve months of writing at that average rate would produce a total premium stream before commission of $2.40 for the year - 24%.       And you still own the stock. I know, I know. There are times when the stock would be called away and you would have to buy it back. Or, if you are determined not to lose the stock, you would have to protect it from being called out by repurchasing or rolling the short calls. (But there are ways to protect the stock that are fairly painless - something I teach in CallWriter seminars, by the way. If you want to learn the tricks of generating a kickin' income from your stock portfoliio, come to one of our seminars. What you will learn can make you a lot of money.) But the $0.20 per month premium stream is not at all unrealistic. Yet - even if you only averaged $0.10 a month in premium, the annual income generated on the shares is $1.20, which is 12% before commissions. Portfolio writing is well worth doing, and every stock investor should be doing it. Let's hit this point again: the BXM has found that, in a decline, the buy-write covered call actually produces better returns than simply holding the stock. Doesn't this strongly indicate that stock investors should be writing call options during market declines? Yes it does, and yes they should. It is fascinating - in light of the BXM results - that CBOE continues to teach in its option education materials that covered call writing is a bullish strategy for use in an uptrending market. Yet the BXM is a buy-writing strategy, not a portfolio writing strategy, CBOE admits that it performs better than stock ownership in declining markets! You would expect better returns in a decline from writing a portfolio for premium income rather than merely holding it through the decline and not writing calls on it, obviously. But the BXM assumes a series of monthly buy-writes, not writing a portfolio. They teach one thing while their BXM shows quite the opposite - declines actually are a better time for buy-writing! The real point is that stock investors should be writing their portfolio all the time, in up markets and down. The fact that the stock is going up is no excuse not to write calls. It is certainly possible to buy back calls periodically on an advantageous basis, since most stocks pull back at some point. You don't always have to make a choice between letting the stock appreciate or pulling in call income - you can do both. If you are not sure how this works, come to my seminar. Covered Call Index: Covered Calls Work The CallWriter Method of writing covered calls is different yet. While many CallWriter members have extensive stock portfolios, it is essentially a buy-write strategy. We buy stocks for the express purpose of writing calls on them. It involves picking the best and most stable stocks from among the population of stocks with the highest covered call returns - which we present on our covered call lists. How hard is that? It just takes a little work on your part. Our approach is a far cry from writing an entire index, dogs and all.       Here is how the BXM assumptions differ from the CallWriter Method: The BXM makes no attempt, as does the CallWriter Method, to analyze individual stocks for covered-call suitability; The BXM assumes that the nearest call strike above the money is always written; it does not select the best call strike at the time in light of technical analysis, market conditions and return offered; Unlike the CallWriter Method, the BXM is entirely passive and mechanical; the BXM does not close out trades to minimize a loss or maximize returns, nor does it include any rolls of the short calls. If the BXM were based on buying only those SPX stocks picked in accordance with the CallWriter Method, returns would be much higher. Proper trade construction and savvy trade management would further increase returns. While many of the S&P 500 stocks might on a given day be considered good covered call trade candidates by applying the CallWriter Method, many would not! This is why the BXM and funds that attempt to duplicate the BXM’s success do a bit better than the S&P 500’s performance, though they substantially decrease risk. *     *     * The BXM certainly gives the lie to the buy-and-hold strategy, doesn't it. The numbers in this case just don't lie. If you believe in buying and holding stocks, then by all means do so - but milk an income from those stocks with covered calls. Covered call writing is gaining adherents every day, and the BXM indicates why: it increases returns and decreases risk. Neither I nor anyone else can say it any better than that.