Hang around the halls of the Street long enough and you’ll be inundated with all sorts of jargon. One of the most satisfying endeavors in life is to travel from ignorance to understanding to mastery of a subject. For dollar seeking drones like us, that topic is trading and understanding the language of finance.
The first time I read the Wall Street Journal I was a babe in the woods. Sure, I could pronounce the words, but I was oblivious to the meaning. Now, I’m a well-oiled writing machine with a vocabulary the size of Delaware.
Why, yes, yes indeed.
There’s a particular phrase I suspect you have come across in your journey, but have yet to fully grasp its relevance. It’s known as risk-adjusted returns. I wanted to take a deep dive into the topic for selfish purposes. And what better way to learn than to teach it to the masses? Here goes…
Investors tend to focus on the market’s final destination. In 2013 the S&P 500 was up 30%, in 2014 the S&P 500 was up 11%, year-to-date it’s up 3%, so on and so forth. For attentive traders, however, it’s not just the final destination that matters but also the path traveled to get there. Was it a windy route punctuated by surprising twists and turns? Or, was it a steady ascent with nary a setback?
Case in point: The overall return on two different stocks over two years was unch (that’s trader speak for unchanged, because, I mean, who has the time to say the entire word, ya know?). In the chart of Stock A below, you’ll notice it started at $43, dropped to $7 amid an oh-my-gosh-we’re-all-gonna-die descent, then recovered viciously back to $43. Stock B started and ended at $43 as well, but remained in a relatively narrow range the entire time.
To say that both stocks are unchanged over two years is true, yet fails horrifically in conveying the whole story. What’s it matter if a stock rallies 30% over the year if it was so volatile in the interim that it knocked you out? Obsession with return without thoughts of risk is dangerous. Because, again, it’s not the final destination that matters near as much as the path you have to travel to get there.
Now you get an idea of why the risk-adjusted return is a useful metric. It looks at the returns offered by a particular investment but then adjusts it for the level of risk you had to stomach in order to capture the return. Let’s say in the prior example that both stocks actually delivered a positive return of 5%. Since stock B exposed you to much less risk along the way it provided the superior risk-adjusted return.
Though there are a number of ways to measure risk (beta, r-squared, Sharpe ratio, etc…), it’s standard deviation that gets thrown around the most often. Consequently, that’s what I’ll reference for the rest of today’s discussion. Honestly, I’m not interested in delving into the mathematics operating behind the scenes. I’d prefer to focus on the more practical aspects of risk-adjusted returns and, more specifically, illustrate how viewing investments with this in mind should make you very, very interested in trading options.
First, consider the annualized return and standard deviation of the S&P 500 from June 30, 1988, to Dec 31, 2011. Why do we care about the S&P 500? Two reasons. First, it provides a backdrop to compare alternate investment approaches to and second, it gives you an idea on what the typical buy and hold investor has experienced with their hard-earned dough that’s sitting in U.S. large-cap stocks for the past couple of decades. Take a look at the following graphic which I snagged from a paper published in February 2012 by the Asset Consulting Group. I’ve highlighted the annualized return and standard deviation of the S&P 500 with red boxes. Ignore the other stats for now.
The S&P 500 has generated an annualized return of 9.1% while exhibiting a standard deviation of 15%. In other words, the 15% standard deviation was the amount of risk or volatility you had to live through in order to capture the 9.1% return. Though the return was admirable, particularly in comparison to the interest received in a savings account, your path was replete with gut-wrenching whoops and whirls. Now, consider the ways you could improve the risk-adjusted return. Since there are only two variables there are really only two ways the performance could improve. Either you generate a better than 9.1% return for the 15% standard deviation you’re experiencing or you reduce the standard deviation while capturing the same (or somewhat similar) return. For example, suppose you have a strategy that generated a 9.1% return but only had a standard deviation of 11%. Or, maybe you have a strategy that scored a 10.5% return with a 15% standard deviation. In either case, you’re capturing a better risk-adjusted return.
The question of interest, then, is how can we generate the better risk-adjusted return? Might there be some magical heretofore unknown asset class that generates stock-like returns with bond-like volatility? Unfortunately not. And yet, investors willing to add options to the mix will be happy to learn that it definitely is possible to score better risk-adjusted returns. Yep, the option Gods dole out more returns for less risk to one and all who wish to accept their gracious gifts.
Are you ready to learn what the gift is? Drum roll, please…
It’s none other than the buy-write and selling cash-secured puts. Today we’ll tackle the former. Perhaps in my next newsletter, we’ll delve into the short put concept. Let me remind you of the twin advantages of the buy-write (aka the covered call, covered write, or covered stock): monthly income and downside protection. The disadvantage is you cap your upside. You may not be aware of this but the mighty C-B-O-E created a handful of Strategy Benchmark Indexes that allow traders to see how well a particular strategy has performed when deployed consistently on the S&P 500 Index month after month. The one of interest for today’s commentary is the CBOE S&P 500 BuyWrite Index which trades under the ticker BXM. Here’s the strategy description straight from the horse’s mouth:
“The BXM is a passive total return index based on (1) buying an S&P 500 stock index portfolio, and (2) “writing” (or selling) the near-term S&P 500 Index (SPXSM) “covered” call option, generally on the third Friday of each month. The SPX call written will have about one month remaining to expiration, with an exercise price just above the prevailing index level (i.e., slightly out of the money). The SPX call is held until expiration and cash settled, at which time a new one-month, near-the-money call is written.”
Let me break that down for you. The Index is buying the S&P 500 and selling one month slightly out-of-the-money call options. Then, riding to expiration and letting the call option settle. Rinse and repeat. How might you expect BXM has stacked up versus simply buying and holding the S&P 500? Your basic understanding of the buy-write should give you some clues. For starters, it should definitely outperform in sideways to down markets since you’re capturing premium that buy-and-holders aren’t. On the flipside, the BuyWrite Index will underperform in strong up markets (you cap your upside, remember?). Additionally, you probably experience less volatility since the premium received from the short call helps buffer some of the downside each month. Now, let’s look at BXM from a risk-adjusted return perspective to see if it delivers as expected. I’ve highlighted the annualized return and standard deviation for BXM below (blue boxes, duh).
First, BXM delivered a 9.4% return versus the S&P 500’s 9.1% return. Not a rousing victory, but a victory nonetheless. Bear in mind the time frame includes the massive bull market of the 90s, a golden age for buy-and-holders, and yet the S&P 500 still underperformed over the entire duration. Loser.
But suppose you’re not convinced. After all, 0.3% is a rounding error and it takes effort, not to mention commission, to sell calls every month. Well, take a look at the standard deviation and pause for a moment. You hear that? It’s your skepticism melting away. At 10.7% the volatility experienced by BXM is almost 30% less than straight buying the S&P 500. That means the drawdowns aren’t as extreme, nor are the short-term upshots in profit as vertical. And that’s a good thing. Because you’re one of those emotional humans. And nothing gets your fear and greed going like massive swings in your account value. BXM reduces account fluctuations, which reduces your emotions, which increases the likelihood that you’ll stick with the strategy and not muck it up with your meddling paws.
Are there extended periods of time where the S&P 500 trounces BXM? You betcha. Sometimes you feel like the village idiot for capping the upside. Take the last five years for example. As shown below in painful simplicity, the S&P 500 is up 75.49% while the BXM is only up 46.37%.
Yes, yes, I know what you’re thinking: BXM, you suck!
Curb your knee-jerk judgments young padawan. You must beware the short run. If you’re in the game for the long haul – which, dare I say, is every one of us – then it’s the overall performance you care about. Plus, as I’ve outlined oh-so-meticulously earlier you should care not just about returns, but risk-adjusted returns. And as proven, on a risk-adjusted basis buy writes are superior to just buying the S&P 500.
So buy-write away.
Financial freedom is a journey
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