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Can You Beat the Market? Part 3


Comparing performance of buy-write indexes with a simple buy-and-hold.

Editor's Note: This is Part 3 in a multiple-part series. Part 1 can be found here, Part 2 can be found here, Part 4 can be found here, and Part 5 can be found here.

The data is available for download at the CBOE. But I've saved you the trouble and shown the data in graphical format. The performance of each of the three buy-write indexes is compared with a simple buy-and-hold for the same index.

When you look at the graphs, it's important to know that the time periods differ widely. BXM was constructed earlier than the others, and although it may be possible to collect and use data from earlier times, it hasn't be done (BXM is available back to 6/30/1986).

These two indexes have been averaging similar results most of the time. During the very strong, bubble-building years of the late 1990s, buy-and-hold, as represented by the Standard & Poors Total Return Index (SPTR) performed much better than a portfolio that held the same stocks, but against which covered calls were written.

And that makes sense. Writing covered calls limits potential profits. That's the price that must be paid during raging bull markets. But such markets aren't common and writing covered calls outperforms sufficiently to make up for those very bullish years -- for this portfolio -- an investment in the 500 largest companies listed for trading.

When the bubble-bursting market decline began, BXM, the Buy-Write Index outperformed and made up for those under-performing years. During the recent rally (since March 2009), the unhedged portfolio has once again done better, and SPTR has almost caught up with BXM. The bottom line for investors is that during the 21 years of available data, those who wrote covered calls fared at least as well as those who owned a diversified portfolio of large cap stocks.

Question: Is this result good enough to claim that covered call writing provides "enhanced returns"? Probably not in dollar terms. But what is true is that BXM provided a less volatile, smoother ride for those who adopted this strategy. Reduced volatility is very desirable, and although most unsophisticated investors prefer to see extra profits, the idea of owning a portfolio that provides less volatile returns ranks near the top of the list of "good attributes" for an investment portfolio.

Please note: It's not a good idea to replicate the BXM strategy by owning all stocks in an index and writing index calls. It's simpler to buy ETFs that mimic the performance of the specific index that interests you, and write covered calls on that. The proper ETF for mimicking the BXM strategy is SPY. You can use QQQQ as a substitute for NDX and IWM to represent RUT. For large cap stocks, BXM performs well. How about buy-writes for other indexes?

This graph illustrates what can happen when the market rises so rapidly that covered call writers are left far behind. In 1999 the performance of NDX (NASDAQ 100 Index) is so much better than that of BXN (CBOE NASDAQ 100 BuyWrite Index), that I truly find it difficult to believe. During 1999, NDX more than doubled from 454 to 917. During the same year, BXN was up by 43%, but that outstanding return was dwarfed by the bullish performance of NDX. Those who rode the rally unhedged collected big-time. On this graph, that 43% return for BXN looks unimpressive.
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No positions in stocks mentioned.

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