Options Theory: What you Can Learn from the CBOE S&P 500 BuyWrite Index ($BXM)
March 25, 2018
Last update: July 2021
Years ago the Chicago Board Options Exchange (CBOE) rolled out a slate of strategy benchmark indexes. The purposes, I suspect, were multi-fold. First, it provided a way for traders to see how a strategy like covered calls or condors would have performed when systematically deployed each month on an Index like the S&P 500. Second, once an index is created, fund providers can launch exchange-traded funds designed to track the index thereby providing a way for traders to access a sophisticated strategy by merely buying a fund. That way they don’t have to execute the system themselves.
From an educational standpoint, I find it incredibly enlightening to use these indexes to illustrate the characteristics of varying options strategies. Today we’ll look at one that tracks the performance of a hypothetical covered call strategy on the S&P 500. Specifically, the index sells one-month slightly out-of-the-money calls and holds them to expiration. Then a new one-month call is sold. You can track the index using the ticker BXM.
When teaching about the covered call (aka buy-write) strategy, I typically highlight four key advantages it provides versus buying and holding stock.
- First, the monthly premiums act as downside protection against small losses in the stock.
- Second, the monthly premiums have the potential to provide cash flow.
- Third, the gains from covered calls reduce your cost basis in the stock and thus increase your probability of profit.
- Fourth, selling covered calls against a stock position reduces the volatility you experience in the position’s P/L. That, in turn, can create a better risk-adjusted return.
Because Wall Street is a world of trade-offs, this quartet of pros is counterbalanced by one glaring con – your reward is limited. The net effect is that covered calls outperform buy-and-hold in down, neutral, and slightly bullish markets while underperforming in aggressively bullish markets. It’s not that you don’t profit when the market stages a rip-roaring rally, you just don’t benefit as much as if you left your shares uncovered.
Take a close look at the accompanying ten-year chart of the BuyWrite Index (BXM – gray line) overlaid with the S&P 500 (SPX – yellow line) below. The first five years (2008 to 2013) show how BXM reigned supreme. As designed the monthly writing of covered calls buffered your losses in the heat of the ’08 crash. While SPX fell some 50%, BXM only slipped 40%. Furthermore, the volatility suffered by BXM along the way was decisively less than SPX. Just look at the difference in the fluctuations of the lines. The gray one, well, wiggles less. And that arguably makes it easy to stay the course with a covered call position.
With the rampage that was 2013’s bull run, buy-and-hold finally bested the covered call system. And it’s yet to relinquish the lead. What we’re witnessing is far from curious, it’s predictable. Uncovered stock positions are supposed to win the day when asset prices balloon. That’s their time to shine, and shine they are.
The gap between the two strategies will gradually shrink during the next downturn or if neutral markets once again return.
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