Buy them right EQUITY

July 5, 2006 06:19 AM

Investors have added more than $13 billion to buy-write strategies through the past year, so says the Chicago Board Options Exchange (CBOE). This is a sign that investors are comfortable with the concept and believe it fills a need. But what exactly are buy-write strategies?

There is certainly no conventional answer to that question, and there isn’t even consensus on what the strategy should be called. Some call it buy-write, while others call it overwriting and some call it covered call writing. Regardless, the idea, while not new, has been gaining a significant amount of attention from average investors.

A buy-write strategy involves buying a security, then writing a call option connected to that security. The call can be inthe- money or out-of the- money and it could have a short or long time until expiration. The income from selling the call could be spent or reinvested back into the program. Although the strategy involves a simple transaction, implementing the concept can be far more complicated.

In summer 2004, the CBOE commissioned a case study on the BXM, or the buy-write index. This index is designed to measure the performance of a theoretical covered call strategy using index options. The BXM measures the return of ownership of the S&P 500 while writing call options barely out-of-the-money with one month until expiration. Income is reinvested back into the strategy rather than being distributed, and transaction costs and taxes are not considered.

The greater awareness of covered call writing has increased the average investor’s comfort level with this terrific investment tool, and it certainly won’t be long until various forms of covered call writing strategies are constructed to fulfill a variety of different investment needs.


Investment professionals often bend over backward to classify a strategy into preconceived buckets, but covered call writing should not be pigeonholed. Like many investment strategies that use derivative securities, covered call writing can be molded into exactly what it needs to be. When we realize what it can do, we can put it to work to help our portfolios meet our investment goals. Whether institutional or individual, portfolios are usually constructed so that they include a combination of two distinct types of investments, each with a unique role: those that are designed to generate income and those that are designed for capital appreciation. Pretty much any portfolio will be weighted toward one end of that spectrum.

At this point, buy-write programs have been mostly designed with similar characteristics to the BXM, but the BXM cannot serve as a suitable replacement for stocks or bonds because it behaves somewhat like both. In the future, buy-write programs likely will be constructed with far more specific goals that will allow them to fall into the capital appreciation or fixed income categories.

Historically bonds have fulfilled the role of income generators. According to the Investment Company Institute, more than $1.3 trillion is invested in U.S. bond funds, but most of them would be at risk of negative performance in a rising interest rate environment. The current low interest rate environment, combined with a future that may see more rate increases than decreases, necessitates a substitute for traditional fixed income for the income-generating element of most portfolios.

Investments designed for capital appreciation have traditionally been structured mostly from stocks. Throughout the past 20 years, stocks have returned more than 12% annualized and that includes the worst bear market since World War II. Stocks have clearly given investors what they expect from their capital appreciation investments, but future returns from stocks likely will not match the last 20 years. To maintain the level of capital appreciation that we’re used to, we’ll likely need to look somewhere other than plain vanilla equity positions.

In an environment where both stocks and bonds are likely to leave investors short of their respective goals for income and capital appreciation, solutions must be found that can make up the difference. Covered call writing can serve as basis for those solutions.


Unfortunately, there isn’t one ideal method for constructing a buy-write program that can solve the shortcomings of both traditional fixed income and capital appreciation investments, but the concept can be molded into the necessary solutions in each case. Let’s look at each in kind.

A solution for the shortcoming of bonds must include an income generator with a “principal” element that will not lose value though time. This obviously reflects the financial behavior of a bond position. Bond prices go down when interest rates go up, so a suitable substitute must retain principal in a rising rate environment.

Generating income from covered call writing is fairly straight forward. Depending on the prevailing volatility environment, selling barely out-of-the money calls on the S&P 500 Index could yield well into double digits on invested capital per year.

This shows the potential for income generation that covered call writing provides, but prudence is essential on how to use that income. Given the volatile nature of the S&P 500, generating that much income by selling barely out-of-the-money calls requires restricting positive market returns — even after the inevitable market decline. Such restrictions can result in the total return of the investment being hamstrung by participating in all the market declines, but in none of the recoveries, which would cause the “principal” to deteriorate throughout time.

But do we really need a bond substitute that generates a 20% yield? Probably not. The total return from long-term government bonds in the future can be estimated from their current yield, which is between 4% and 5%. Compared to that, an investment that kicks out 10% income per year with no loss in principal would prove highly valuable. A buy-write program can be set up with that as its realistic goal.

The key to this strategy is to reinvest a portion of the income back into the program, such that income is generated while principal value is maintained.


If the broad U.S. stock market only returns 7% or 8% per year through the next decade or so, as many expect, finding new means of greater capital appreciation is critical. In short, investors in the future will need to outperform the market as a whole to meet their return expectations.

Anyone can cheaply and easily earn the market’s return by investing in an index fund or exchange-traded fund designed to match the return of the market. However, out-performance from security selection and market timing have proven woefully inadequate, so investors who hope to outperform will need to be a bit more creative. This is where covered call writing can help.

The BXM is a passive methodology of implementing a buy-write program, so generating performance returns as they would have been in the past is reasonable. Although impossible to predict, future performance of the BXM might be as strong and consistent as it has been in the past. If so, that performance could serve as the socalled “alpha” portion of a portable alpha strategy.

Alpha is loosely defined as “outperformance” relative to a certain benchmark. We know that if the future returns of the broad stock market are in the mid single digits, outperformance becomes considerably more important to achieve. By taking the past returns of the BXM and “porting” them to a synthetically replicated exposure to the S&P 500, an investor could have achieved significant outperformance. Considering that most large cap U.S. stock funds failed to outperform the S&P 500, such outperformance would have proven quite valuable.

The concept of covered call writing is gaining popularity, but is still in its infancy. Investors are warming up to the idea, but professionals have not yet implemented it in ways that can solve real performance problems facing the traditional investment portfolio. In the next issue, we will examine specific ways this strategy can be used to solve these problems.

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

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