Buy-write strategies, in which an investor buys a stock or a basket of stocks, and sells call options that correspond to the stock or basket of stocks, are becoming increasingly popular. This strategy can be used to enhance a portfolio's risk-adjusted returns and reduce volatility at times when an investor is willing to forgo some upside potential in the event of a bull market in stocks. Buy-write strategies are now also being wrapped in structured investment products, via options priced on buy-write indices.
For example, the Chicago Board Options Exchange Dow Jones Industrial Average BuyWrite Index, BXD, measures the performance of a hypothetical buy-write strategy based on a portfolio of the stocks included in the Dow and options on the Dow. From Oct. 31, 1997 through May 31, 2006, the annualized returns for the BXD were 7.0%, compared to 6.9% for the DJIA Total Return Index, with standard deviations of monthly returns of 11.8% for BXD and 15.7% for DJIA.
Interest in the buy-write strategy grew after the development of buy-write benchmark indexes. The CBOE has introduced five buy-write benchmark indexes with the ticker symbols BXD, BXM, BXN, BXR and BXY. The Australian Exchange and other non-U.S. exchanges also recently introduced buy-write benchmark indexes.
Interest in buy-writes also jumped after the publication of studies by Duke University Professor Robert Whaley and by Ibbotson Associates research firm. Ibbotson published a case study on the BXM Index and the initial performance of the first money manager licensed to run strategies linked to a buy-write index. The study found that over the 16-year period studied:
(1) The buy-write index had the best risk-adjusted performance of the major domestic and international equity-based indexes studied;
(2) Based on the historical data, when a 15% allocation of the buy-write index was added to a moderate portfolio, volatility was reduced by almost a full percentage point with almost no sacrifice of return; and
(3) The risk-adjusted return for the buy-write strategy (as measured by the skew-adjusted Stutzer Index) was 38% higher than that of the Standard & Poor's 500. The Ibbotson study did note that the Sharpe Ratios were 0.75 for the BXM Index and 0.53 for the S&P 500, but the study emphasized the use of the skew-adjusted Stutzer Index because of the negative skews for both the BXM (-1.25) and S&P 500 (-0.46) indexes.
The rest of this Learning Curve focuses on the performance of the CBOE DJIA BuyWrite Index, BXD. The BXD Index was announced by CBOE in 2005 under an agreement with Dow Jones Indexes, and is based on prices of options on the Dow--DJX--traded at CBOE. The price of the DJX is 1/100 of the DJIA. The BXD is a passive total-return index based on:
(1) buying a DJIA stock index portfolio; and
(2) "writing"--or selling--the near-term DJX Index "covered" call option, generally on the third Friday of each month.
The DJX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level, i.e., slightly out of the money. The DJX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.
Performance
Sources Of Returns
A prudent investor may ask how the BXD can have slightly higher returns and significantly less volatility than the DJIA, if the markets were efficiently priced, and what are the sources of returns for the BXD Index?
A key finding of the Ibbotson study and earlier studies by Morgan Stanley (1990) and other academics is that implied volatility often has been higher than realized volatility for index options. The index options were priced so that the sellers of the options received more options premium than the subsequent realized volatility would have indicated. This fact has helped boost risk-adjusted performance for buy-write strategies; if implied volatility had been at the same average level as realized volatility, then options sellers would have received lower option premium and achieved lower returns.
Another key source of returns is the fact that the BXD Index strategy is taking in options premium on the third Friday every month. In the past some options writers would sell three-month options four times a year. An options writer running a BXD strategy would have taken in options premium 12 times a year and would have taken more advantage of the time decay or theta of the options than an investor who sold four three-month options in a year. For the period from October 1997 through May 2006, an investor who had engaged in the hypothetical BXM strategy would have taken in options premiums at an average rate of 1.88% per month, or more than 22% per year. Exhibit 3 shows the options premiums that were generated on select Expiration Fridays. After 2002 the CBOE DJIA Volatility Index--VXD--has been at relatively low levels, but in mid-June 2006 the VXD did rise above 21 to its highest level in more than three years, and so there is potential for the BXD strategy in the near future to generate higher yields than it had in 20042005.
Investment Products
Dealers including Morgan Stanley and Merrill Lynch have written structured investment notes or funds linked to buy-write indices. These tend to offer both a target income and growth on capital.
Conclusion
More than USD20 billion has been invested in buy-write investment products in the last two years, and many investors seeking higher yields and lower volatility are expected to continue to explore the buy-write strategy.
This weeks Learning Curve was written by Matt Moran, v.p. of business development at the Chicago Board Options Exchange.
