Since the 1970s, investors have looked to covered call strategies as a reliable source of equity yield and enhanced risk-adjusted performance. In 2002, the Chicago Board Options Exchange (CBOE) developed the S&P 500 BuyWrite Index (BXM) to track the performance of a passively managed, monthly at-the-money, buy-write strategy on the S&P 500 Index. Following the introduction of the BXM benchmark, call writing gained wide acceptance as institutions and high-net-worth investors looked to monetize the volatility risk premium embedded in public equity markets.
While strategies based on these benchmarks are now widely incorporated into broader multi-asset class plans, most remain passively managed. However, through an active approach that incorporates market information embedded in the option prices, plan sponsors can greatly enhance their buy-write performance.
Right now, the marketplace is dominated by buy-write strategies that favour a passive approach to option selection and option position management. More specifically, call options are systematically sold at a pre-determined strike price on a set trading schedule—generally the third Friday of every month. The inefficiencies created by pre-determined trading schedules and predictable security selection create alpha opportunities for strategies that have the flexibility to trade away from the pack.
An actively managed strategy seeks to outperform passively managed buy-writes in all market environments by employing volatility-based analytics that guide optimal call option positioning. The goal of active management is to generate positive risk-adjusted returns with reduced impact on the equity appreciation potential in periods of strong equity appreciation. This approach is based on three key factors:
Option strike: An actively managed buy-write strategy will sell call options ranging between 1% in-the-money and 5% out-of the-money. The success of an actively managed strategy requires accurate and consistent estimation of market risk relative to the level of the available option income.
Option tenor: Weekly, monthly, and two-month options may be deployed in an actively managed buy-write strategy. In periods of low volatility and positive equity performance, longer dated call options are typically sold. The longer dated calls are a greater source of income when the equity risk premiums are low. In periods of high volatility, shorter dated options are deployed since they provide the greatest downside cushioning characteristics.
Volatility indicators: A diverse array of realized and implied volatility measures serve as the primary trigger for both option strike selection and option trading tenor.
Option writing strategies may offer income investors an opportunity to generate a high level of income from most equity portfolios. Implementation does not require the client to terminate relationships with existing equity managers and they can act as an enhancement to long only equity portfolios with market-like returns and reduced portfolio risk over a market cycle. Finally, an actively managed buy-write strategy provides strong total return performance relative to going to a passively managed route.
Eric Granat is Derivatives Analyst, Pyramis Global Advisors