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business newsUsing the Buy-Write Strategy to Benchmark Your Portfolio, Smooth Returns
Premium selling strategies are a great way to get the wind of time decay at your back. But it's important to understand your risk and reward, and most importantly, your expectations.
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Two years later the CBOE S&P PutWriting Index (^PUT) was launch. This is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts. By having cash to secure the maximum loss this is considered a covered position. Learn details here.
The two positions are essentially the same in terms of their risk/reward profiles. Both have limited upside and both are exposed to a dramatic drop in price. Most importantly both benefit from a price that is flat to trending slightly higher and a decline in implied volatility. Over the years they have both produced better returns than just owning the S&P 500 Index with approximately 25% less volatility.
There is actually a growing set of factual statistics (are there any other kind?) that indicate that put writing will produce incrementally better performance without any additional risk as puts typically demand slightly higher implied volatility or premiums. But as the table below shows, 2011 was something of an outlier as the ^BXM provided 30 basis points over the ^PUT .
My guess is that in 2011, as many companies returned to or increased their dividends, this accounted for the ^BXM outperformance. The largest drawdowns during 2011 were during late July to early August in which S&P declined 17%, ^BXM lost just 11% and the ^PUT declined 13% during the period.
While there are a number of firms and funds such as Claymore Covered Call Fund or Rampart Partners that offer products that benchmark or mimic both the ^BXM and ^PUT, these are strategies you can replicate on your own.
But before engaging in either of these approaches, a few caveats:
- These Are Both Labor- and Commission-Intensive Strategies. The two benchmarks are frictionless in that they do not account for any fees that will be accumulating by rolling positions 12 times a year. Expect a minimum of 1% annual drag on your performance.
- Volatility Levels Are an Essential Part of the Relative Returns. You can see from the table above that the best relative returns have come over the longer-term time horizons. This can be attributed to the “reversion to the mean” element of volatility levels. Obviously the best time to establish premium selling strategies would be when implied volatility is high; but that of course is a relative term. 2011 offered an attractive mix of very high volatility with a very flat price performance. But unless one remained very disciplined to the program it would have been easy to get chopped to bits.
- Margining and Dividends. Depending on your account type, a covered call can be margined differently than a short put. Even though the ^PUT is based on a fully “cashed covered” positioned, the different margining would result in different return on investment (ROI). Also, it's important to be aware that a covered call, in which one owns the underlying security -- this is true even of an ETF like the Spyder Trust (SPY) -- will collect a dividend. While the expectations of a dividend are supposed to be embedded in the option's price, in practical terms the assurance of the steady income will often add a few basis points of return.
- Beta Neutralizer. Given that a put sale or a covered call establishes affective buy prices below current levels but locks in affective sale prices, it's no surprise these strategies come with a beta lower than their benchmark. This means that the drawdowns won’t be as great, nor will the profits be as much in a strong bull market.
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