Aurora Borealis
1 January 2016 CFA Institute Journal Review

Option-Writing Strategies in a Low-Volatility Framework (Digest Summary)

  1. Nitin Joshi

Buy-write or covered call option strategies have risk characteristics that can be studied to identify whether they are materially different from those of stock-only low-volatility strategies. The authors evaluate whether they provide diversification benefits to low-volatility investors.

What’s Inside?

Buy-write strategies exhibit risk–return profiles similar to those of low-volatility equity portfolios, but such strategies have not been included in studies related to low-volatility investing. The authors examine whether buy-write strategies offer new and attractive sources of premium and find that both strategies reduce exposure to market beta and that buy-write strategies offer additional risk–return benefits.

How Is This Research Useful to Practitioners?

Low-volatility strategies have been popular in the investment community over the past decade. The low-volatility anomaly refers to the outperformance of low-beta stocks compared with higher-beta stocks because of investors’ preference for the latter, which results in overvaluation and, ultimately, lower returns. Given the increasing acceptance of low-volatility strategies, the anomaly presents unexpected investment opportunities.

The authors compare the risk and return profiles of buy-write strategies with those of conventional low-volatility equity strategies and find that buy-write strategies do not load on the value, small-cap, and betting-against-beta factors. But they do exhibit a market beta lower than 1, which suggests that the volatility reduction for both categories of low-volatility strategies is attributable to a reduction in market beta. Their performance is the result of a combination of different factors, which means they provide diversification benefits. Moreover, buy-write strategies do not suffer from the sector concentration risks that are prevalent in equity-only low-volatility strategies.

By performing option attribution analysis (e.g., delta, gamma, vega, theta) in order to capture the higher, nonlinear moments, the authors complement the factor attribution of the two strategies’ different risk exposures. The analysis highlights the trade-off that call option writers make: accepting uncertain and potentially unlimited gamma loss in exchange for a certain time premium. This finding provides empirical support for the investor behavior “preference for lottery” and “leverage constraint” hypotheses. Finally, the authors note that implied volatility risk, a key option price input, is small in the long run because of its mean-reversion pattern.

Comparing different buy-write strategies with various maturities and rebalancing frequencies, the authors find that three-month-to-maturity index call options rebalanced monthly are more effective at capturing buy-write outperformance. The relatively higher return in conjunction with a reduction in risk is inconsistent with the prediction of standard models and suggests overvaluation. The authors attribute the higher return to the skewness premium that option writers gain in exchange for assuming potentially unlimited losses.

How Did the Authors Conduct This Research?

The authors use the Chicago Board Options Exchange (CBOE) OptionMetrics database. The dataset includes closing bids and offers of all options and indexes quoted across all exchanges for the period January 1996–December 2012, which allows for the assessment of buy-write performance in different market conditions. The authors choose data related to European options, which eliminates the complexity of analyzing optimal early exercise. The data include computed delta, theta, gamma, vega, and implied volatility statistics that are used in option attribution analysis.

The authors examine only one simple version of the buy-write strategy and its natural variants. They invest 100% long into the S&P 500 Cash Index and then sell S&P 500 call options. This strategy is similar to the CBOE S&P 500 BuyWrite Index (BXM). Variants considered include different option maturities and rebalancing cycles.

The benchmark BXM is constructed by writing a one-month at-the-money long position in the S&P 500. The authors extend the BXM strategy by writing three-month call options with rebalancing frequencies of one month and three months to form additional variants. They consider five different strikes of the call options, from 5% in the money to 5% out of the money with 2.5% increments.

By comparing the buy-write strategies with the S&P 500 Total Return Index, the authors illustrate the impact of the covered call strategy on portfolio risk and return and show that the strategy of writing covered call options on the S&P 500 improves the overall portfolio’s risk-adjusted returns during the time period. The improvement is the result of a strategy that involves rebalancing long-dated options on a monthly basis, which yields enhanced risk-adjusted return.

Abstractor’s Viewpoint

The authors cover various buy-write strategies over a range of strike price levels and infer that the improvement in risk-adjusted performance results from the skewness premium that option writers gain in exchange for assuming the tail risk of a potentially unlimited loss. The authors satisfactorily explain the success of buy-write strategies in a traditional low-volatility framework.

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