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Moneyness and the Profitability of Shorting Equity Options

| | Posted in: Equity Options

Covered Calls Advisor Jeff Partlow commented: “Selling a cash-secured put is essentially equivalent to a covered call when done at the same strike price and expiration date. But I’ve observed that cash-secured put sellers tend to select more conservative out-of-the-money strike prices, whereas covered call sellers tend to establish more aggressive out-of-the-money strike prices. Also, the result in ‘Outperformance from Mechanically Selling Covered Calls on a Stock Index’ is questionable to me because the July 2004 ‘Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index’ by Ibbotson Associates and the October 2006 ‘An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy’ by Callan Associates show, respectively, that 2% out-of-the-money and at-the-money covered call strategies outperform a buy-and-hold approach.”

None of the research in the “Equity Options” category investigates option trader behaviors in enough detail to indicate differences in behaviors between covered call and cash-secured put sellers. The implications of long-term market drift for the risk-adjusted returns from shorting the one-month-to-expiration options generally considered in this research may be extremely small compared to the implications of: (1) volatility of the underlying; (2) the volatility risk premium; and, (3) option trading frictions.

The following research suggests that going further out-of-the-money improves returns from selling equity calls and puts:

“Outperformance from Mechanically Selling Covered Calls on a Stock Index” (the findings of which you question): “Except for the 5%-out-of-the-money one-month-to-expiration variation, the buy-write strategies lose money on call positions.”

“Abnormal Returns from Selling Index Put Options?”: See the table at the end of the blog entry.

“Is 40% Per Month Shorting Index Puts a Fair Return?”: “Systematically selling one-month-to-expiration, unhedged index puts generates extraordinary profits: 39% (95%) per month for at-the-money (deep out-of-the-money) puts.” See also the last chart in the blog entry and the linked critique.

“The Volatility Risk Premium and De-biased Equity Option Returns”: “…speculators may be able to exploit the volatility risk premium by selling short-term deep out-of-the-money put options and all maturities of deep out-of-the-money call options on the broad stock market, especially during periods of high volatility.”

“Returns for Call Options on Individual Stocks”: “The higher the strike price, the worse the average returns for call options on individual stocks.” [For buying, not selling, so the opposite is true for selling.]

The following research somewhat disagrees (based on trading frictions):

“Strategies for Investing in Options of Individual Stocks”: “…the converse that short option strategies improve by starting further out of the money does not necessarily hold, because higher percentage bid-ask spreads limit profitability.”

Reservations regarding the practical application of these studies are:

  1. Some of the studies implicitly use leverage, with the amount of leverage likely varying with moneyness. Leverage amplifies performance with respect to a buy-and-hold benchmark (comparably leveraged buy-and-hold is arguably a better benchmark for such studies).
  2. Some of the studies ignore some or all trading frictions, impounding an unfair advantage over buy-and-hold.

The Callan Associates study you cite states that the analysis “does not take into account significant factors such as transaction costs and taxes” and is apparently silent on accounting for the bid-ask spread. The predecessor Ibbotson Associates study states “the bid price is conservatively used to determine the price received for writing the call.” However, per the June 2008 “Description of the CBOE S&P 500 BuyWrite Index (BXM)“: “Beginning on May 21, 2004, the methodology for the BXM was revised. …on the third Friday of the month, the new S&P call option generally will be deemed sold at a price equal to the volume-weighted average of the traded prices (‘VWAP’) of the new call option during the half-hour period beginning at 11:30 a.m. Eastern Time.” Seller-initiated trades and buyer-initiated trades represent two different distributions of prices. Since the BXM strategy is always in the buyer-initiated distribution, it is arguable that a mixed-distribution average such as VWAP overstates the realistic expected revenue from iterative call writes (especially for individual traders). Variation of return with moneyness may be non-linear, as described in “Performance of Buy-Write Strategies for Australian Stocks” (i.e., some degree of out-of-moneyness is good, but too much hurts).

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