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Can You Beat the Market? Part 3


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

As we now understand, that huge rally was based on nothing more than hope, and those Internet companies weren't worth the prices at which they were trading.

By year end 2002, the excessive gains of NDX were wiped out by the market decline and the two indexes were trading near the same levels (NDX was still higher). If the bulls never exited or hedged their positions, as most didn't, the out performance soon disappeared.

This demonstrates that a volatile index, such as NDX, can perform much better during rallies, but also much worse during declines. In simper terms, it's a very volatile index and writing covered calls reduces that volatility, but at the expense of smaller profits. At least that's the story over the limited lifetime of the available data.

Bullish investors may not be well served by any strategy that limits profits. But, not every bullish investor is aggressive, and deciding whether to hedge (reduce the risk of owning) a portfolio is one of your major decisions.

Over the nine short years for which data is available, there's little to recommend either strategy -- although buy-writing has the edge. The interesting data is missing -- and that's the bubble years from 1998 through 2000. It's very likely RUT outperformed its buy-write index during those years.

I'm attempting to draw valid conclusions from the data, but we must remember that data covering 10 to 21 years isn't likely to tell the whole story. We've seen some strong markets and some weak markets, and that tends to make the data more reliable.

Your task is to gather information that allows you make a decision on how to invest/trade. Investors want to build a portfolio that suits their needs. Reducing risk should be (ok, that's my opinion, not a fact) near the top of those needs.

Writing covered calls is a worthwhile strategy. It provides the comfort of a less volatile portfolio, and depending on the type of stocks owned (large cap versus smaller, highly volatile companies) can even provide better returns. Reduced volatility with good returns is a big plus.

But, covered call writing is a bullish strategy and doesn't fare well in bear markets. It's much better than buy and hold, but what about the conservative investor who prefers much more protection against large losses. After a short break, we'll continue with a discussion of collars.
No positions in stocks mentioned.

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