The value of option buy-writes

With levels of the S&P 500 continuing to move higher, the chance for a return reversal or a slowdown increases. Strategies that can change the return to risk mix when return plateau can have significant value-added. A simple strategy is a buy-write on the market. The buy-write generates greater current income through booking option premium in exchange for cutting the upside returns.

Over the long-run, 1988 to the end of 2006, the BXM buy-write strategy through the CBOE has performed better than the S&P 500 total return index. A buy-write will not do well if the market is moving up without much volatility. If there are sustained periods of decline or sideways movement, the buy-write strategy will out perform a buy and hold strategy.

More importantly, there is a significant risk reduction from the option writing strategy relative to a buy and hold strategy; however, this comes at some cost. There is an increase in the negative skewness of the return distribution. The upside is capped while the downside is not. The median return will be higher because of the addition of premium to the buy and hold return which is the compensation you receive for the negative skewness.

The value of these options strategies is tied to the utility function of the investor. A good rule of thumb is that investors like large odd moments of the distribution, the mean and skewness. Investors dislike high even movements of the distribution, volatility and kurtosis. Hence, a strategy that can increase the mean and reduce volatility would be preferable, but this has to be compared with the higher moments. The higher negative skew of buy-writes has to be contrasted with the kurtosis that may be found with a buy and hold strategy. Put another way, the issue is whether the added return to risk for employing options is worth the price of more negative skew.

While the buy-write return profile is well-known, it is important to think of the benefit of sculpting the distribution of returns especially if the expectation is that future returns will not have the same positive momentum as seen over the last 12 months.