Buy-Write – Are Covered Calls All They’re Cracked Up to Be?

�

Good market, bad market, panic-stricken market, whatever, the most popular option strategy is always the plain, vanilla buy-write, a covered call strategy where you simultaneously purchase the stock and write the call contract. The appeal is that you can get close to market returns at reduced volatility. Or can you?

The CXO Advisory wrote about a study of the Australian market that came to very different conclusions.

“Do buy-write strategies, wherein investors buy stocks and simultaneously sell matched out-of-money call options, generally outperform their underlying stocks? In other words, do option premiums more than compensate for any sacrifice of capital gains? In their January 2010 paper entitled “The Efficiency of the Buy-Write Strategy: Evidence from Australia,” Tafadzwa Mugwagwa, Vikash Ramiah and Tony Naughton examine the performances of buy-write strategies on the Australian Stock Exchange for portfolios formed monthly, quarterly and yearly at different levels of call option out-of-the-moneyness. They test the profitability of buy-write strategies during weak and strong markets. They measure the effects on buy-write returns of underlying stock liquidity (turnover ratio), dividend yield, firm size, book-to-market ratio, earnings per share and price-earnings ratio. Using prices, firm fundamentals and out-of-the-money call option prices (actual and modeled) for 179 stocks over the period January 1995 through October 2006, they conclude that:

• Underlying stocks consistently outperform buy-write strategies. For instance, a buy-write portfolio formed monthly with options 0% to 2% out-of-the-money generates an average annual return of 7.6%, compared to 13.7% for the underlying stocks.

�

• Buy-write strategies do not realize significantly lower volatilities than underlying stocks for 10 of 12 portfolios studied.

�

• Buy-write strategies do not significantly outperform underlying stocks during weak market conditions (negative past returns and high volatility). During strong market conditions, buy-write strategies underperform underlying stocks.

�

• Buy-write strategy profitability tends to increase with option out-of-the-moneyness to a point, but then decrease with out-of-the-moneyness when deep out of money.

�

• Perhaps due to an Australian preference for options with a maturity of about three months, quarterly buy-write formation intervals work best. Monthly formation intervals are worst.

�

• Screening for high earnings per share, small size, high dividend yield, low trailing and forward price-earnings ratio and high book-to-market ratio have similar positive impacts on both buy-write strategies and underlying stocks.”

This flies in the face of both common perception and data I studied for my book, Options Volatility Trading: Strategies for Profiting From Market Swings.

In fact, after running numbers I came away more favorably impressed with buy-writes than before I began my research. My thought was that you give up too much upside in bull moves, but as it turned out, those stretches were relatively brief. In other words, you’d tend to have a month, or maybe a quarter where you’d kick yourself for writing calls, but within six months the rally would tend to stall enough that the added income from the writes caught you up.

In down moves or generally flat stretches, it’s pretty obvious buy-writing is preferable. It’s like creating your own dividend.

And I didn’t find resetting monthly differed much from resetting quarterly.

So why the discrepancy?

Well, perhaps there’s something unique about Australia (besides Foster’s and The Wiggles). And possibly (OK, definitely) they’re stat work was more rigorously parsed than my own.

Even so, you can intuitively tell when a buy-write has outperformed — whenever the markets are not rising swiftly, and that just doesn’t happen as often as we think.

And as to not seeing lower volatility in a buy-write portfolio than a straight stock portfolio, that really doesn’t make any sense. A buy-write has to outperform on a decline and underperform on a rise; it’s just a question of magnitude.

While I respect their work, I just don’t agree with their conclusions.