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When Buy-Write Goes Very Wrong


With volatility tanking, it might seem like the best play. But think again.

How about some other ways to look at volatility?

Well, there's Average True Range. It should roughly approximate Historical Volatility. Or at least, move in the same direction. And indeed it has, here in SPY, as it's completely in the tank.

Up above that, we have Bollinger Band Width. It actually bottomed in early June and rose earlier this month. This reflects that even though the day-to-day moves are rather muted, the fact that they all went the same direction gives the appearance of volatility over a longer time frame. I touched in this in the last post, as does Wayne at Sigma Options.

So with volatility in the tank, one would reasonably expect that the best play lately was a buy-write.

Guess again. Here's the CBOE's Buy-Write Index versus the SPY over the past 6 months.

The best relative outperformance was off the March "Danica Bottom." It's a little counterintuitive in that you'd think if you got long at the lows, the best idea was to just buy stock and not give away upside with the call write. Note from the ATR study above that actual stock volatility was way higher than now. Likewise, you'd think with non-existent stock volatility, the buy-write made relatively more sense -- like in July and early August.

The answer is that performance of the buy-write depends on the actual options pricing. In March, the options tanked ahead of actual SPY volatility, hence the early outperformance. In July and August, they continue to overprice actual volatility, as I've mentioned about 42,000 times the past month.

So in other words, the true relative benefit of buy-writing as opposed to straight-buying hasn't been realized. And it won't be until options volatility better reflects the reality of the depressed stock volatility.

Now it sounds patently ridiculous to recommend buy-writing both after a big stock rally and after the VIX has hit the skids. But if you're convinced Abby Jo and the green shoots crowd is right and you're itching to get long here, sure seems like buy-writing makes more sense than a straight long.
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