In this article, the performances of common portfolio option writing strategies are analyzed against their historical performance from 1989 to 2010. From this analysis, two option writing strategies emerged as the clear winners. Their historical returns outperformed the S&P 500 while generating less risk. These strategies and others are explained in further detail below.
S&P 500 Total Return (SPTR) – Benchmark for this analysis
Although it may be a surprise to some investors, the commonly followed S&P 500 index does not include dividends in its price performance. However, the S&P 500 Total Return index does include dividends and is a better index to evaluate historical stock performance. Therefore, I’ve used this index as the benchmark to compare the performance of the option strategies below.
CBOE S&P 500 BuyWrite Index (BXM)
Buy-write portfolios also known as covered call strategies can enhance portfolio returns when the market is flat or trending lower. This buy-write strategy holds the S&P 500 index and writes a one-month near-the-money covered call on the underlying every month. This strategy limits upside potential while partially hedging downside risk.
Historically, this strategy’s average annual return is slightly lower than SPTR but has a much lower monthly standard deviation of return, thus generating a higher Sharpe Ratio. The Sharpe Ratio measures a portfolio’s outperformance adjusted by its risk (Annual Return – Risk Free Rate / Standard Deviation).
Investors looking to generate smarter returns as measured by the Sharpe Ratio, may consider these two products that allow investors to participate in this buy-write strategy:
CBOE S&P 500 2% OTM BuyWrite Index (BXY)
This strategy is similar to the BXM strategy above. However, this strategy sells a 2% OTM call option on the S&P 500 index instead of a near-the-money call. By selling an OTM call, this increases the upside potential but consequentially provides less of a downside hedge. Therefore, this strategy produces a higher return than BXM and SPTR but at an increased level of risk, thus generating a Sharpe Ratio similar to BXM but still higher than SPTR.
I have not currently found any ETFs that replicate this strategy. However, investors can replicate the strategy by writing 2% OTM covered calls on SPY (S&P 500 ETF).
CBOE S&P 500 95-110 Collar Index (CLL)
Like the previous two strategies, this strategy also holds a position in the S&P 500 while hedging the position with a collar. This collar consists of buying a 3-month put at 95% of the S&P 500 index value while selling a 1-month call at 110% of the S&P 500 index value. The short call helps finance the purchase of the put, which protects against stock price decreases. The problem with this strategy is that the cost of the put protection is not fully offset by the premium collected from the short call. Therefore, this strategy only outperforms the other strategies during years where the stock market experiences large declines. Since the market increased more frequently than decreased during this time, the cost of insurance was a drag on returns. There were only two years (2001 & 2008) out of 22 years analyzed where the S&P 500 Total Return experienced large enough declines that CLL outperformed other strategies. Therefore, this strategy significantly underperforms the S&P 500 Total Return index and all other option strategies discussed in this article on an absolute return basis and on a risk adjusted basis.
I have not currently found any ETFs that replicate this strategy nor do I recommend investors to replicate this strategy.
CBOE S&P 500 PutWrite Index (PUT)
Unlike the aforementioned strategies, this strategy does not hold a position in the S&P 500. Instead this strategy is long the S&P 500 by writing a 1-month at-the-money PUT on the S&P 500 index while holding a collateralized cash position invested in Treasury Bills. This strategy has displayed the highest return of any strategy mentioned in this article while producing the lowest standard deviation, therefore, its Sharpe Ratio is also the highest.
Generally, there is a tradeoff between risk and return. As a result, the put strategy bucks the trend since it has the highest return and lowest standard deviation. Ennis Knupp’s article “Evaluating the Performance Characteristics of the CBOE S&P 500 PutWrite Index” explains that the source of this excess return stems from two investment characteristics:
- A disconnect between the implied volatility of put options and realized volatility of the underlying. Ennis Knupp found that 20-day realized volatility has been consistently less than the VIX index (which measures implied monthly volatility of options traded on the S&P 500) from 1990 to 2008.
- Capturing a larger time decay by selling 1-month vs. 3-month put options. For instance, Ennis Knupp estimates that a 3-month option has half the time premium of a 1-year option, which is four times longer than the 3-month.
The economic rationale for the structural imbalance between implied volatility (VIX) and realized volatility is that demand for put options for portfolio insurance outweighs the number of sellers that exist in the market, thus increasing price and implied volatility of puts options on the S&P 500.
While I have not currently found any ETFs that replicate this strategy, this is certainly a strategy worth executing in a marginable account. Investors should also be aware of the risks of this strategy. Although these put options are collateralized with an underlying cash position, investors writing put options can realize extreme losses if the S&P 500 experiences significant declines. Additionally, the strategy must be performed every month no matter whether the market is increasing or decreasing. Some investors may not have the stomach to sell puts during substantial market declines but this is a great time to collect premiums when the VIX Index is really high.
The following matrix shows each strategy’s historical average annual return plotted against its Sharpe Ratio. Note, PUT and BXY are the two strategies that simultaneously produce high returns and high Sharpe Ratios.
Summary of Strategies
As shown in the table below, the two option strategies outperforming the S&P 500 and strategies that I am considering implementing in the near-future are the CBOE S&P 500 2% OTM BuyWrite and CBOE S&P 500 PutWrite strategies.
Data Sources: Historical performances taken from CBOE Micro Site.
Disclaimer: Please consult your financial advisor before making investment decisions. Depending on your circumstances and risk tolerance, the strategies in this article may not be suitable for all investors.
Additional disclosure: I am considering implementing some of the strategies in this article within the next month.