Two Potentially Winning Options Strategies

I wrote a review yesterday on Get Rich with Options: Four Winning Strategies Straight from the Exchange Floor (Agora Series).

I thought a follow-up was in order for readers interested in learning more about options.

In my opinion the best, free site for options investors is the Chicago Board Options Exchange, cboe.com. There is an abundance of free material on the site - you could literally spend weeks on the site.

I want to highlight two strategies/studies on the CBOE site. The first is a buy-write strategy which CBOE tracks using the CBOE S&P 500 BuyWrite Index (BXM). According to CBOE the strategy involves:

(1) buying an S&P 500 stock index portfolio, and (2) "writing" (or selling) the near-term S&P 500 Index (SPX^SM) "covered" call option, generally on the third Friday of each month. The SPX 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 SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.

A study on the strategy can be found here (pdf). In addition, a second study shows some of the benefits of a buy-write strategy. A buy-write strategy essentially matched the performance of the S&P 500, however, it had significantly less volatility. Sound familiar? Moving average studies detailed on this site have had similar results. The buy-write study:

In 2006 Callan Associates, an investment services consulting firm, published a new study on the CBOE S&P 500 BuyWrite Index, with an analysis of performance from June 1988 through August 2006. Their study builds upon the earlier studies done by Professor Robert Whaley (now at Vanderbilt University) and by Ibbotson Associates. The new Callan Associates study had several key findings, including:

• BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk. (The compound annual return of the BXM was 11.77% compared to 11.67% for the S&P 500, and BXM returns were generated with a standard deviation of 9.29%, two-thirds of the 13.89% volatility of the S&P 500.)
• The risk-adjusted performance, as measured by the monthly Stutzer Index over the 18-year period, was 0.20 for the BXM vs. 0.15 for the S&P 500. A comparison using the monthly Sharpe Ratio yielded similar results (0.22 vs. 0.16, respectively), confirming the relative efficiency of the BXM over the 219-month study period.
• The BXM underperformed the S&P 500 during most rising equity markets and consistently outperformed the S&P 500 in all periods of declining equity markets, demonstrating the return cushion provided by income from writing the calls.
• The BXM generates a return pattern different from that of the S&P 500, offering a source of potential diversification. The addition of the BXM to a diversified investor portfolio would have generated significant improvement in risk-adjusted performance over the past 18 years.

There are closed-end funds, mutual funds, and ETFs which employ a buy-write strategy. Two ETFs by PowerShares are PQBW (buy-write on the Nasdaq 100) and PBP (S&P 500 buy-write). Free INO Trend Analysis on PQBW and PBP can be found here.

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A second strategy, selling naked puts which was highlighted in Get Rich with Option is also featured on CBOE. The CBOE has an index which tracks a naked put selling strategy. An introduction:

In June 2007 the Chicago Board Options Exchange (CBOE) announced that it is beginning to publish daily data on the value of the CBOE S&P 500 PutWrite Index (ticker symbol PUT). PUT is an an award-winning benchmark index that measures the performance of a hypothetical portfolio that sells S&P 500 Index (SPX) put options against collateralized cash reserves held in a money market account. The daily historical data for the PUT Index now extends back to June 30, 1986.

The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.

Sound risky? It can be - a collapse in the markets like the one seen in 2008 can put you on the hook for purchasing shares at a much higher price then the current market price. However, the historical data on PUT is impressive. Ennis Knupp did a study in December 2008 (pdf) on PUT. From June 30, 1986 to October 31st, 2008 employing the strategy yielded the following results:

The systematic sale of put options over the entire time period would have earned an annualized return of 10.32%, before fees, with an annualized standard deviation of returns of 9.91%. The risk and return of the PUT Index compare favorably to the S&P 500, which earned annualized returns of 8.77% with a volatility of 15.39% over the same time period. The CBOE S&P 500 PutWrite Index was announced in June 2007 and the track record of returns was generated using historical options prices, with the assumption that each put option was sold at the bid price.

Again, we see significantly less volatility when using this strategy versus the S&P 500. Selling naked puts can involve significant risk; however, that risk is mitigated if the seller has cash on hand to cover the amount of stock on which they are selling puts. This is the strategy with PUT - thus, your potential downside is actually less then holding the S&P 500 since you received the initial premium for selling the put. I would highly recommend reading the Ennis Knupp study in full to gain a further understanding of the strategy.

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