Blog - Investing Notes

March 7, 2007 - Outperformance from Mechanically Selling Covered Calls on a Stock Index

Are there simple and safe equity option strategies that work? In their January 2007 paper entitled "The Risk and Return Characteristics of the Buy Write Strategy On The Russell 2000 Index", Nikunj Kapadia and Edward Szado evaluate returns for a mechanical buy-write (covered call) strategy based on the Russell 2000 index. Strategy variations encompass selling calls the day before each options expiration date that are: (1) at the money, 2% away from the money or 5% away from the money; and (2) one or two months from expiration. The strategy closes each expiring call position at intrinsic value. Using data from January 18, 1996 to November 16, 2006 to analyze returns on an monthly expiration-to-expiration cycle, they find that:

• The buy-write strategy consistently outperforms the Russell 2000 index on a risk-adjusted basis when implemented with one-month-to-expiration calls. The annualized return for the at-the-money, one-month-to-expiration variation over the entire sample period is 9.21%, compared to 10.67% for the Russell 2000 index alone. However, the options strategy has lower risk by several measures (such as monthly volatility, Sharpe ratio and maximum drawdown).
• During the worst subperiod for the strategy (2/03-11/06, when the Russell 2000 index advances strongly with low volatility), the strategy generates two-thirds of the index return at just half its volatility.
• The two-months-to-expiration variations generally underperforms both the one-month-to-expiration
  variations and the Russell 2000 index. (See the first chart below.)
• The underlying Russell 2000 index makes the dominant contribution, an average of just over 1% per month, to buy-write strategy returns. Except for the 5%-out-of-the-money one-month-to-expiration variation, the buy-write strategies lose money on call positions. (See the second chart below.)
• The contribution of the volatility risk premium (implied minus realized volatility) is critical to the performance of the strategy.

The following chart, taken from the paper, shows the growth of $100 investments in the Russell 2000 index, the one-month-to-expiration at-the-money call-write strategy and the two-months-to-expiration at-the-money call-write strategy. While the underlying index generates the highest raw return, the one-month-to-expiration strategy consistently outperforms both other alternatives on a risk-adjusted basis.

The next chart, also from the paper, depicts average contributions to the overall returns of the one-month-to-expiration buy-write strategy variations. The dominant contribution comes from the underlying Russell 2000 index. Call positions mostly lose money. Transaction costs are comparable to losses on call positions.

The authors note that previous studies have consistently found that a similar strategy for the S&P 500 index outperforms that index on a risk-adjusted basis. They note also that the Chicago Board Options Exchange offers several buy-write indexes.

In summary, a strategy of mechanically selling one-month-to-expiration covered calls on the Russell 2000 index consistently outperforms the index based on risk-adjusted (but not raw) returns.

For related research, see Blog Synthesis: Equity Options.