Versatility of buy-write strategies

June 29, 2006 08:18 AM

Last month we outlined the theory behind the buy-write trading strategy. Buy-write, also called covered call writing, programs have experienced stratospheric growth recently and now include more than $18 billion in assets. Although the growth has been impressive, the concept remains in its infancy as virtually all the assets are managed with the same general philosophy. The idea can, however, be stretched and molded to form different investments to meet different needs.

Most investments fall into one of two distinct categories: those that seek capital appreciation and those that generate income. Although exceptions exist, stocks are expected to provide capital appreciation and bonds are used for generating income. Being able to classify an investment as one or the other is an important aspect of effective portfolio construction, but most buy-write programs are not easily classified as stock-like or bond-like. They may still merit consideration, but the concept could prove more effective if implemented with a more focused performance agenda.

The most significant growth for covered call writing came after the Chicago Board Options Exchange (CBOE) commissioned the development of a passive buy-write index. This index, the BXM, showed the performance of a completely decisionfree foray into covered call writing.

Most buy-write strategies today are similar to the BXM, which behaves uniquely relative to both stocks and bonds. In other words, BXM-like programs can be expected to grow assets modestly and generate income, but not a tremendous amount of either. Thus, we can bend the BXM’s rules a little to create some different investments that target more specific goals.


As a capital appreciation tool, the BXM has good potential. The principal inhibitors to the BXM’s asset growth qualities are the call options written barely out-of-the-money (at the strike price just above the current index’s price).

Upward moves in the market are capped at that strike because any additional appreciation is offset by an equal liability to buy back the call. But what if a call option was written a bit further out-of-the-money? It wouldn’t provide as much income, but would allow for greater capital appreciation. An example can illustrate how that might work.

On Nov. 21, the S&P 500 index futures closed at 1257.00. The BXM’s philosophy, if used in the futures market, would dictate selling a call at the next highest strike with one month until expiration — in this case, the December 1260 call.

Selling this call at 10.3 would have generated $2,575, but capped capital appreciation at only 0.2% until the options expired the third Friday in December.

Let’s loosen the cap a little and write a call approximately 1% out-of-the-money so we can capture 1% per month in capital appreciation if the market advanced that much or more. Selling the December 1270 would do the trick and would also generate $1,450 in income.

So, we have an unleveraged position that is on pace to generate 5.5% in income — $1,450 times 12 divided by $314,250 (1257 x $250) — and allows for 1% per month in capital appreciation. This can be particularly compelling if future stock market returns are, as many expect, below historical averages, because giving away the upside will be far less painful than it would be if the market posts 20% returns.

Certainly the stock market will not go up 1% every month, but even if we captured just 5% of the upside during a given year, combining that with the 5.5% in income could result in greater capital appreciation than the stock market in general.


To create a fixed-income generating vehicle, we sell a higher-priced option at a lower strike price. This will produce more cash, but we don’t want to just spend all of the income immediately.

Monte Carlo simulations indicate that if all the income from a covered call writing program was spent, the total value of the investment would soon deteriorate to zero because it endures all the downside moves of the stock market and enjoys none of the upside.

A better idea is to kick out the income you need and reinvest the rest. Unlike a bond, which will return the principal to the bondholder at maturity, the “principal” of a covered call writing strategy is the cash used for investing in S&P 500 futures, which must be replenished after negative stock market performance.

Looking again at Nov. 21, we see the 1250 call could have been sold for 16.5, which would have generated $4,125 in income — a 15.8% annualized yield on an unleveraged investment of $314,250. Spending that much income without reinvesting anything would lead to total depletion of assets. So some of the income should be reinvested back into the program in order to maintain the “principal” value of the investment.

How much should be reinvested? That depends, and requires some compromise. The more income spent, the greater the risk of principal loss. Some studies show if 10% of covered call writing income is spent and the remainder reinvested, the principal value of the investment could be maintained. Even if only 8% was generated in income, such a yield would prove far superior to most fixed income strategies in use today.

However, it should be noted that certain market environments could make even that much income difficult to generate while still preserving principal. Transaction costs and taxes should be considered as well.


Now that we can see how a buy-write strategy can be created to achieve more specific investment goals, we can discuss the specific financial tools for implementation. Our examples used futures and futures options, but most buy-write programs are constructed with S&P 500 index (SPX) options.

The problem with using SPX options is that there is no underlying security that can be delivered if the written calls are exercised. More to the point, selling SPX calls as part of a buy-write program would be considered a “naked” position, necessitating hefty margin requirements that would lessen the efficiency of the program.

One potential solution may be found in an entirely different derivative: exchange traded funds (ETFs). There are ETFs that have options connected directly to them. Using ETFs might allow a buy-write program to be constructed without excessive margin requirements, but doing so brings about a new set of problems.

Of the ETFs that have options connected to them, most are relatively illiquid, with wider bid-ask spreads. Also, most ETF options have a limited number of strike prices, inhibiting opportunities to build precise strategies.

Finally, there is the tax issue. An investor who generates short-term option income while holding the underling ETF for the long term may be forced to pay income tax on a position that actually lost value. However, having the investment completely contained within a futures program may allow more favorable tax treatment of profits and the opportunity to offset losses.

The greater awareness of covered call writing has increased the average investor’s comfort with this terrific investment tool. Additionally, creating strategies through the use of futures and futures options may prove more efficient and effective than using securities. As the concept becomes more widely understood, we can say with a high degree of confidence that various forms of covered call writing strategies will be designed and offered to fulfill far more specific investment needs.

Michael J. Oyster is a CFA, CTA and is the author of Mission Possible, Achieving Outperformance in a Low Return World.

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