During the last decade, equity option writing strategies have gained significant interest with fund managers and individual investors. While the first registered equity option writing funds in the United States were launched in 1977, the category has grown substantially during the last 10 years. In addition, a number of equity option writing indexes have been introduced by the Chicago Board Options Exchange (CBOE) in the last 15 years.
Here, we discuss six strategies that use various option writing methods to track the returns of the S&P 500 while reducing risk.
“Option index roster” (left) provides an overview of the CBOE benchmark indexes. The BXM and BXMD are covered call indexes in which the S&P 500 is purchased, while at-the-money (ATM) or 30-delta out-of-the-money (OTM) S&P 500 calls are sold. PUT is a covered put index which holds Treasury bills as collateral and sells ATM puts each month on the S&P 500 matching the notional value of the portfolio. CMBO is a combination of covered call writing and covered put writing. Each month, the CMBO sells 30-day 2% OTM S&P 500 calls covered by a long position in the S&P 500 and sells one-month ATM S&P 500 puts covered by a corresponding long position in Treasury bills. The BFLY index represents a long iron butterfly strategy that sells a one-month ATM/5% OTM bull call spread and sells a one-month ATM/5% OTM bear put spread each month. Finally, the CNDR index represents a long iron condor strategy that sells a 20-delta OTM/5-delta OTM bull call spread and sells a 20-delta OTM/5-delta OTM bear put spread.
The most obvious factordriving the indexes is exposure to the underlying S&P 500 index. The BXM and BXMD have direct exposure to the S&P 500 by holding stock. Others have an indirect long exposure to the S&P 500 through their option exposure. It is worth noting that gamma causes the S&P 500 exposure of these option selling strategies to change as the S&P 500 index rises and falls. These strategies are also exposed to the volatility of the S&P 500. More specifically, option writing strategies outperform the S&P 500 on a risk adjusted basis over time if the implied volatility of written options is greater than the S&P 500 volatility that is actually realized over the life of the option. The difference between these volatility measures is often referred to as option richness. While S&P 500 option richness varies significantly over time, it has been on average positive and a potentially significant source of returns for the strategies (see “Options richness,” right).
Option selling results in monthly income from premium collection; unless, of course, short options expire in-the-money (ITM).
We will now discuss the characteristics of each strategy including historical performance from the earliest available history of the corresponding CBOE indices of July 1986 through the end of 2015. It is important to note that the period of analysis includes the market stresses of 1987, 2000 and 2008. Studies of short options strategies that do not include such market events will potentially overstate returns by not including the large losses normally associated with short options positions during these events.
BXM – ATM Buywrite Index
The BXM index represents the returns to a buy-write or covered call strategy in which the S&P 500 is purchased, while one ATM S&P 500 is sold each month. An ATM buy-write strategy essentially sacrifices any positive returns of the S&P 500 in exchange for the premium collected from selling the ATM calls. S&P 500 returns will be offset by the short calls. However, if the S&P 500 drops, the returns will be enhanced by the premium collected from the short options, which expire worthless. The ATM S&P 500 buywrite strategy could be an attractive alternative if an investor believes that the S&P 500 will not increase over the month, or they are willing to sacrifice potential increases in the S&P 500 in exchange for a fixed income in the form of premium collection (see “A better way,” right).
BXMD – OTM BuyWrite Index
The BXMD index represents the returns of a buy-write strategy in which the S&P 500 is purchased while 30-delta OTM S&P 500 calls are sold. An OTM buy-write strategy sacrifices positive returns above the initially OTM strike in exchange for the premium collected from selling the OTM calls. If the S&P 500 increases significantly in value from the date the calls are sold, the gain from the long S&P 500 position will be partially offset by any loss on the now ITM short calls if the S&P 500 exceeds the strike. However, if the S&P 500 drops over the month or rises slightly, the returns will be enhanced by the premium collected (see “More upside,” Right).
PUT – Covered ATM PutWrite Index
PUT represents the returns of a put-write or covered short put strategy in which ATM puts on the S&P 500 are sold each month while the notional value of the S&P 500, position is invested in Treasury bills to cover any possible losses on the short puts. Payoffs on the ATM put-write strategy are similar to the ATM buy-write; however, returns can vary based on strike selection, dividends and imperfect put-call parity. The ATM put-write strategy is exposed to the downside of the S&P 500 without the benefit of being exposed to the upside. To compensate for this exposure, the strategy collects significant put premiums from selling the ATM puts. If the S&P 500 rises, the puts expire worthless and the investor keeps the premium. However, if the S&P 500 drops, the puts expire ITM, drawing against the funds available to invest in Treasury bills. The yield of the bills can contribute significantly to the strategy returns if interest rates are high. The ATM S&P 500 covered put-write strategy could be an attractive alternative if an investor thinks that the S&P 500 will not increase during the month. The PUT generally collects slightly more option premium than the BXM. In addition, since option time value tends to decay quicker as the option approaches expiration, the weekly put-write index (WPUT), which sells covered ATM one-week S&P 500 puts each week, collects significantly more premium over time than the PUT.
It is worth noting that these figures do not include transaction costs, which are expected to be much higher for WPUT (see “Another way” right).
CMBO – OTM Call/ATM Put, Covered Combo Index
CMBO represents the returns on a covered combo strategy, a 2% OTM S&P 500 covered call and an ATM S&P 500 covered put-write. The covered combo is the only index discussed that has a greater potential downside exposure than a long position in the S&P 500. The payoff of the covered combo is similar to the payoff of the OTM covered call. However, below the strike price of the short put, the covered combo is exposed to the downside of the S&P 500 both through the long S&P 500 position and through the short put. Thus the downside is levered up, potentially resulting in large losses if the S&P 500 has a significant drop. This strategy has limited upside due to the short call and unlimited levered downside. However, since it is selling two options each month, it collects significant premium to compensate for the risk. If the S&P 500 is flat over the course of a month or rises by less than the 2% that the short call is initially OTM, the strategy can significantly outperform the S&P 500.
The strategy is appealing in times when an investor is confident the S&P will remain range bound. If the S&P is unchanged for the month, CMBO should significantly outperform the BXM and PUT (see “Covering your bases,” right).
BFLY – Iron Butterfly Index
Unlike the first four strategies, the final two strategies — the BFLY and the CNDR — are non-directional, volatility strategies. The payoff diagrams of the previous strategies were asymmetric. In general, they benefited from a rise in the S&P 500 while softening the downside exposure. The BFLY and CNDR payoff diagrams are symmetric, experiencing the same loss for an equivalent rise or fall in the S&P 500. BFLY represents the returns of a long iron butterfly — a combination of a short bull call spread (short ATM call and a long 5% OTM call) and a short bear put spread (short ATM put and a long 5% OTM put). Like the covered put-write index, the BFLY limits its risk by investing the notional value of the S&P 500 in Treasury bills. The iron butterfly has the potential for limited gains and losses. The maximum gain occurs if the S&P 500 remains unchanged.
It experiences its maximum loss if the S&P 500 closes at or above the long call strike or at or below the long put strike. This strategy may be appealing when an investor thinks that the S&P 500 will be flat for the month or if they believe that the market is significantly overestimating volatility. If the S&P 500 is unchanged for the month, the BFLY should outperform the strategies previously discussed (see “Butterfly net,” right).
CNDR – Iron Condor Index
CNDR represents the returns of a long iron condor strategy. An iron condor differs from an iron butterfly in that the ATM short put and call are replaced by an OTM put and call. This results in a wider S&P 500 range under which the iron condor experiences its maximum return.
In exchange for this risk reduction, the iron condor collects less premium. The long iron condor is a combination of a short bull call spread (20-delta OTM call and a long 5-delta OTM call) and a short bear put spread (20-delta OTM put and a long 5-delta OTM put).
Like the covered put-write and the iron butterfly, the CNDR limits its risk by investing the notional value of the S&P 500 in Treasury bills. CNDR has the potential for limited gains and losses. The maximum gain occurs if the S&P 500 remains between the short put and the short call strikes. It experiences its maximum loss if the S&P 500 closes at or above the long call strike or at or below the long put strike. This strategy may be appealing when an investor thinks that the S&P 500 will trade within a narrow range or if they think the market is overestimating volatility.
If the S&P 500 is unchanged for the month, BFLY should outperform CNDR, but that outperformance will quickly fade as the
S&P 500 generates volatility (see “Fly like a condor,” right).
“Tested by fire,” (left) shows how all 10 indexes performed in 2008.
How is it possible that all of these indexes generate positive alpha? Selling S&P 500 options generates significant premium income. Because most options do not expire ITM and that implied volatility is higher than realized volatility over time, one would expect option writing strategies to provide superior risk adjusted returns. This “outperformance” is not to true alpha, but rather to compensation for taking on the risk associated with being short volatility. So what? The historical performance of these benchmark indexes suggests they are valuable strategies that greatly decrease risk by sacrificing a small amount of return. That may be appealing to many investors who are able to tolerate short volatility risk. Calculated performance of option strategies is sensitive to the period studied. Traditional risk measures, which assume normally distributed returns and linear relationships, may not be appropriate for options-based strategies, which tend to exhibit decidedly non-normal return distributions. This is why we looked back 30 years.
Note: All graphs from “Performance Analysis of CBOE S&P 500 Option-Selling Indices” by Black and Szado. 2016 INGARM working paper.