Edge in Selling Options Part I: The Buy-Write

Edge in Selling Options Part I: The Buy-Write


  • 2015 was a great year for buy-writes; 597 bps of alpha was gained over the market due to elevated volatility and a stagnant market.
  • Despite market myths, approximately 30%-35% of options expire worthless.
  • Investors should be aware of the utility options provide for their own purposes or for when evaluating a portfolio manager.

Alpha in Buy-Writes

Alpha can be elusive. Many investors spend their careers chasing fads and attempting ill-fated trades to hopefully boost their performance. Finding these opportunities, historically, required a research team and other scarce trading resources. Now more than ever, these capabilities are freely available to investors through technology. Interest in extracting alpha via options has brought forth the rapid adoption of options as a risk management and return enhancement tool. As such, it’s essential to explore the benefits, risks, and opportunities options strategists provide.

The options revolution began with the launch of electronic trading and the penny pilot program, where options spreads were allowed to be quoted in penny increments. As the cost of trading dropped, both commissions and bid/ask spread-wise, options exploded in popularity, showing consistent volume growth since their inception in 1973. From a macro point of view, options can provide a variety of opportunities. They can serve as an equity type investment vehicle, all the way to being utilized for pure speculation. Options can also be used as a strategic additional source of income when overlaid with stock, also known as the buy-write (most commonly, a long stock and short out-of-the-money call combination).

Buy-writes combine the best of both stock selection strategies and time-decay oriented option selling. While similar in risk to a short put, buy-writes provide exposure to fundamental investing, from the opportunity to collect dividends to the ability to vote. On the other hand, the short call component provides the ability to benefit from time passing and the mean reverting nature of implied volatility.

Selling options against an underlying security is a common strategy. Proponents have suggested that the opposite, buying options, results in losses because 90% of options contracts expire out of the money.  According to the Chicago Board Options Exchange (CBOE), this myth is exaggerated. About 10% of options are exercised prior to expiration. The majority of positions, 55%-60%, are closed before expiration. And finally, despite popular belief, approximately 30%-35% of options expire worthless. While the specifics of the myth are flawed, the idea of collecting premium is sound and can be of extreme value when market direction seems to be mixed and volatility is heightened.

In times of uncertainty, buy-writes perform well. The strategy takes advantage of short term spikes in noise while remaining long and hedges positions during periods of real volatility. The ideal scenario would be moderately bullish prices, so that core longs appreciate in value while short calls expire worthless. For example, the CBOE Buy-Write Index (BXM) that tracks short term buy-writes on the S&P 500 using options struck just above the current index level and one month out, showed gains of 5.24% in 2015 while the S&P 500 posted a total return of -0.73%, essentially 597 bps of alpha.

Buy-writes and other options strategies serve as a great opportunity to generate alpha for investors. Funds that utilize options and other complex strategies are classified as alternative assets. In a recent annual update put out by J.P. Morgan Asset Management, the firm suggested allocating a consistent 20% of capital to alternative strategies and the remainder to stocks and bonds according to risk preferences. The firm noted that across time horizons, the model portfolio with exposure to alternatives grossed higher total returns and experienced lower volatility vs. the traditional stock and bond portfolio. Lowering the volatility of a portfolio is especially key for individuals nearing retirement. While nothing is risk-free, buy-writes certainly do lower overall volatility. Using the BXM again, the theoretical 10-year volatility of this strategy is 372 bps lower than the S&P 500. The strength of buy-writes, and options in general, derive from their ability to profit from rising, falling, and stagnant markets.

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Just blindly selling options will not lead to superior returns, however. As much research that goes into stock selection should go into selecting an option to sell. Moreover, timing the sale is equally important. Environments with low implied volatility (IV) are not as ideal due to lower premiums. Accordingly, context as to where IV stands is important. An indicator of this is IV’s 52 week range. The S&P 500 is currently sitting in the lower end of its IV range, in the 35th percentile now. On the other end of the risk spectrum, a stock with earnings the next day will likely be near its 52-week IV highs, or greater than the 70th percentile due to event risk.

Moreover, there are not many days in the year where IV moves up to advantageous levels. Since 1993, on average, there are only 3 days per month with a drawdown of greater than 1% in the S&P 500.  On these days IV will likely move higher, ideal for a call sale. The price at which the option is struck and the minimum premium collected is equally, if not more, important to consider.

In a study conducted by Goldman Sachs, the firm looked into finding the optimal location of placing a short call for buy-writes. The study concluded that placing a short call 2% out of the money led to the highest returns above the market, according to data aggregated over a 15-year period.

Overall, options are an efficient, transparent, and growing tool investors should consider leveraging for personal investing or should be aware of when evaluating a manager. More specifically, buy-writes are an excellent addition to a well-balanced portfolio. Knowing a product’s risk profile and key benefits will help make asset allocation research easier. Investors interested in learning more about managed investment accounts that utilize options should contact us here.


Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

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