Index Options Writing For Enhanced Yields And Alpha
By Matthew Moran and Mitch Boraz

Over the past 12 years, U.S. investors have faced four investment challenges that were much more severe than they were in the period from 1982 through 1999:

(1) Low interest rates and higher future risk for fixed income

(2) Sluggish equity returns

(3) Higher correlations among many asset classes

(4) Less liquidity for certain investments in times of stress

In light of these challenges, many investors are exploring investments beyond the "traditional" investments of U.S. stocks and bonds. More than $25 billion has been invested in buy-write funds since the 2002 introduction of the first major benchmark for options performance, the CBOE S&P 500 BuyWrite Index (BXM).

Challenge No. 1: Low Interest Rates And Higher Risk For Fixed Income
Many investors think of fixed-income investments as being very safe, and many fixed-income instruments have performed relatively well during the past few decades. For example, as shown later in this article, the Treasury bond index had slightly higher returns than the S&P 500 Index over a recent two-decade period.

However, with interest rates so low in 2012, some commentators are noting that the outlook for U.S. fixed-income investments might not be very rosy. Professor Burton Malkiel of Princeton University wrote in a March 2012 op-ed piece:

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser. Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. … Given the likely trends, U.S. Treasurys and high quality bonds are likely to be extremely poor investments and are very risky.¹

Further, an August 2012 news article noted:

For many investors, the appeal of investment-grade corporate bonds is obvious. Interest rates on Treasury bonds are even lower … But skeptics say the ravenous demand for corporate bonds has pushed yields on the securities down too far to compensate investors for their risk. … When interest rates eventually rise, prices of recently issued corporate bonds will fall. "The guy buying a [new] bond today is a guy buying a certain loss," says Anders Maxwell, a managing director at investment bank Peter J. Solomon Co. "Rates have to go higher, and when they do these low-coupon bonds will drop precipitously in value."²

The average yields in Figure 1 were 6.71 percent for 10-year Treasurys, and 3.07 percent dividend yield for the S&P 500.

Key interest rates in the Wall Street Journal on August 20, 2012, included:

• 0.11 percent: 4-week U.S. Treasury bills
• 0.44 percent: 3-month Libor
• 1.41 percent: 5-year CD
• 1.82 percent: 10-year U.S. Treasury notes
• 1.95 percent: Barclays Capital Aggregate
• 5.93 percent: Merrill Lynch High-Yield 100

In light of the low yields and higher risks for many "traditional" fixed-income instruments, many investors now are exploring a variety of strategies, including the writing of index options, with the goals of enhancing yields and lowering portfolio volatility. This subject will be discussed later in this paper.

Challenge No. 2: Sluggish Equity Returns Since Year 2000
Since the bursting of the tech bubble in the year 2000, many major stock market indexes for developed countries have had sluggish returns, as stocks faced crises such as terrorist attacks and the 2008 financial crisis.

In the period from March 31, 2000 through July 31, 2012, the S&P 500 Index was up 16 percent and the MSCI EAFE Index was up 11 percent, while the CBOE S&P 500 2 percent OTM BuyWrite Index (BXY) was up 59 percent, as it collected S&P 500 index options premiums every month (see Figure 2).

The sluggish stock market performance has been a key factor in the increased disillusionment of many investors toward equity investing. One clear sign of equity disenchantment has been the net new cash flows for different types of mutual funds. As shown in Figure 3, the net new cash flow for each of the past four years (2008-2011) has been negative for equity mutual funds and positive for bond mutual funds.

Challenge No. 3: Higher Correlations Among Many Asset Classes
Another challenge for investors in recent years is the fact that there have been higher correlations of returns among many asset classes, and this fact can make it more difficult to construct a portfolio that is well-diversified. The U.S. pension law known as ERISA requires fiduciaries to diversify "the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so."³

Figure 4 shows that the rolling one-year correlations of weekly returns have risen for some asset classes:

(1) The correlation between the S&P 500 and the S&P GSCI (commodity) Index rose from negative 0.21 on Jan. 8, 1971, to negative 0.02 on Jan. 8, 1993, and then to 0.69 on Aug. 3, 2012.

(2) The correlation between the S&P 500 and the MSCI EAFE Index rose from negative 0.13 on Sept. 14, 1979, to negative 0.02 on Jan. 8, 1993, to 0.88 on Aug. 3, 2012.

(3) The correlation between the S&P 500 and the Russell 2000 Index rose from 0.52 on April 7, 2000, to 0.96 on Aug. 3, 2012.

While the correlations among many "traditional" assets have risen over the past decade, the correlation between the S&P 500 and the CBOE Volatility Index (VIX) fell from negative 0.60 on Jan. 11, 1991, to negative 0.84 on Aug. 3, 2012. In recent years, some investors have explored the possibility of using volatility as an asset class, and using options and VIX-based products for purposes of diversifying portfolios.

Challenge No. 4: Less Liquidity During Stressful Market Periods
During the 2008 financial crisis, many investors became more concerned about the liquidity of their investment holdings.

A GAO report on the 2008-2009 financial crisis noted:

Some plan representatives described significant difficulties in hedge fund and private equity investing related to limited liquidity and transparency, and the negative impact of the actions of other investors in the fund—sometimes referred to as co-investors. For example, representatives from one plan reported they were unable to cash out of their hedge fund investments due to discretionary withdrawal restrictions imposed by the fund manager, requiring them to sell some of their stock holdings at a severe loss in order to pay plan benefits.⁴

In addition, Daniel Wallick, principal, Vanguard Investment Strategy Group, was quoted:

Liquidity was largely ignored before the 2008 crisis. A lot of endowments had liquidity problems because their portfolios were heavily weighted to private equity and capital calls had to be met. The situation back then has made a lot of endowment CIOs consider the impact of alternatives on their portfolios now.⁵

Index Option Writing And Benchmark Indexes
In light of the four challenges listed above, in the past decade, many investors have explored the potential of using relatively liquid index option-writing strategies in order to add gross income, and to enhance risk-adjusted returns for their portfolios.

In the years 2000 and 2001, some options-based investment managers requested that the Chicago Board Options Exchange (CBOE) create some options-based benchmark indexes, and CBOE did so in subsequent years. The remainder of this paper will analyze the performance of four benchmark indexes that sell one-month, cash-settled S&P 500 (SPX) Index options on the third Friday of every month⁶ (see Figure 5).

Certain options-based portfolio managers have said that a long-term aspirational goal of the buy-write strategy is to achieve higher "stocklike" returns and lower "bondlike" volatility. Does past performance of options-based benchmark indexes suggest this goal has been achieved at times?

In the time period from June 30, 1986 through July 31, 2012, the PUT Index rose 1,240 percent, the S&P and BXM indexes both rose about 900 percent, and the CLL and MSCI EAFE (in $US) indexes both rose more than 360 percent (see Figure 6). The BXY Index is not included in Figure 6 because its backtested price history begins in mid-1988.

As shown in Figures 7 and 8, over a recent 20-year period, (1) the PUT and BXY indexes both had higher returns and lower volatility than the S&P 500, MSCI EAFE and S&P GSCI indexes; and (2) three options-based indexes (PUT, BXM and CLL) had less volatility than the Treasury bond index and the two stock indexes. Figure 9 shows the risk-adjusted returns and other statistics for the four options-based indexes highlighted in this article as compared with other widely referenced benchmarks.

In Figure 10, the three options-writing indexes (PUT, BXY and BXM) all are favorably positioned to the northwest, with higher returns and lower volatility than the MSCI World and S&P GSCI indexes. Two questions that have been asked are as follows:

(1) If the PUT and BXM indexes both have had about 70 percent of the volatility of the S&P 500 Index, and if the indexes have been fairly priced for risk and return, why haven’t the PUT and BXM indexes also had about 70 percent of the returns of the S&P 500 Index over longer time periods?

(2) Why were the risk-adjusted returns of the CLL (collar) index so much weaker than the other three options-based indexes (PUT, BXM and BXY)?

Source Of Strong Risk-Adjusted Returns: S&P 500 Options Have Been Richly Priced
One answer to the two questions posed above is that one can look at Figure 11 and the comparison of implied and realized volatility. If the markets were very efficiently priced, one could expect that there would be little to no difference between the implied and realized volatility over the long term. However, the average difference in Figure 11 was about 3.8 volatility points, a substantial number. Several other studies⁷ also have found significant differences between implied and realized volatility.

Why has there been a difference between implied and realized volatility? Professor Robert Whaley wrote:

… there is excess buying pressure on S&P 500 index puts by portfolio insurers. Since there are no natural counterparties to these trades, market makers must step in to absorb the imbalance. … implied volatility will rise relative to actual return volatility. … The implied volatilities of the corresponding calls also rise from the reverse conversion arbitrage supporting put-call parity.⁸

While the three indexes that incorporate option selling (PUT, BXM and BXY) into their methodologies appear to have benefited from the fact that implied volatility usually has been higher than realized volatility, the CBOE S&P 500 95-110 Collar Index (CLL) has not had relatively strong risk-adjusted returns because of the fact that the CLL Index is both a buyer of (richly priced) put options and a seller of (richly priced) call options.

As interest rates for U.S. fixed income have declined, investors continue to search for instruments with higher yields. A yield-based strategy that has grown in popularity over the past decade is the "buy-write" strategy, in which an investor could buy securities and write (or sell) options on those securities. The most well-known benchmark for the buy-write strategy—the CBOE S&P 500 BuyWrite Index (BXM)—was announced in 2002. The BXM Index assumes that slightly out-of-the-money S&P 500 options are written on the third Friday of every month, and the average gross monthly yield for the BXM Index (using the premium received as a percentage of the underlying) has been about 1.8 percent. Figure 12 shows the rolling 12-month gross premiums for the BXM Index, and the rolling 12-month net returns for both the BXM Index and S&P 500 Index. In Figure 12, note that the BXM net return has been pretty close to the BXM gross premiums in times of steadily rising stock markets. However, in years in which the S&P 500 has experienced big drops (e.g., 2001 and 2008), the BXM net return was generally above that of the S&P 500, and far below the BXM gross premiums as a percentage of the underlying.

Managing Of Left-Tail Risk And ‘Black Swan’ Events
After witnessing two big declines in stock index values since the year 2000 (see Figure 2), many investors in recent years have heightened concerns about left-tail risk and catastrophic "Black Swan" events that could harm their investment portfolios. An options strategy that could be explored by risk-averse investors is the "collar" strategy, in which one purchases stock, buys protective put options for downside protection and sells covered calls for income that can help pay for the put premiums. A key benchmark for the collar strategy is the CBOE S&P 500 95-110 Collar Index (CLL), which buys S&P 500 puts for downside protection, and sells S&P 500 calls for income. Note that in Figure 13, the CLL Index was able to lessen much of the left-tail risk. During the 26-year time period, the S&P 500 Index had 13 months with returns worse than -8 percent, while the CLL Index had only one month with a return worse than -8 percent.

Correlations And Diversification
Over the past decade, many investors have become more concerned about challenges to diversification, as there have been increasingly higher correlations among "traditional" investments. As shown earlier in this paper, in Figure 4, the correlations of weekly returns versus the S&P 500 for various indexes were:

• 0.96 for the Russell 2000
• 0.88 for the MSCI EAFE
• -0.84 for the CBOE VIX Index

• -0.70 for the S&P 500 VIX Mid-term Futures Index (SPVIXMTR)
• -0.63 for the S&P 500 Dynamic VIX Futures Index (SPDVIXT)
• -0.60 for the S&P 500 VIX Futures Tail Risk Index – Short Term (SPVXTRST)

Capacity And Liquidity
Some investors who are exploring the possibility of using index options have asked the question, Do the index options markets have the capacity and liquidity to handle large influxes of new institutional funds that will be dedicated to options-based strategies? The listed options markets now offer options on thousands of securities, and the liquidity and capacity of options markets on different securities can vary significantly. The market for options on the S&P 500 Index is the largest listed options market in the U.S. in terms of notional size. Figure 15 provides estimates for the notional value of the average daily SPX options volume, and it uses a 0.5 delta adjustment to make the figure more conservative and realistic as compared with notional value statistics that do not use any delta adjustment. The delta-adjusted notional volume estimate for the average daily volume in June 2012 was about $51 billion. The liquidity and flexibility offered by S&P 500 stocks and S&P 500 options usually have compared favorably compared with investments such as private equity. Investors should do their own due diligence and discuss with their brokers issues regarding capacity and liquidity for any security.

Conclusion
Since 1983, index options have been used by institutional and individual investors for a variety of purposes, including managing risk and generating income with the goal of boosting risk-adjusted returns. Since 2002, investors have had options-based benchmark indexes with which to measure the advantages and disadvantages of key options-based strategies in bullish and bearish markets.

This paper highlights some of the key features of the discussed indexes:

Total Growth. Total growth for the following indexes from June 30, 1986 through July 31, 2012 was 1,240 percent (10.46 percent annualized) for the PUT Index, 886 percent (9.2 percent annualized) for the BXM Index, 903 percent (9.2 percent annualized) for S&P 500 Index, and 390 percent (6.3 percent annualized) for the CLL Index (Figure 6).

Lower Volatility. The PUT, BXM and CLL indexes all had volatility that was about 30 percent lower than the volatility of the S&P 500 Index (Figure 8).

Left-Tail Risk. The worst monthly losses over the 26-year time period for the CLL and S&P 500 indexes were negative 8.6 percent for the CLL Index versus negative 21.5 percent for the S&P 500 Index (Figure 13).

Monthly Premium Income. The average for the gross monthly premiums collected by the BXM Index was 1.8 percent and the index options usually were richly priced (Figures 11 and 12).

Liquidity. The utilization of S&P 500 stocks and S&P 500 index options can provide liquidity and capacity for those investors who prefer flexible access to their capital (Figure 14).

References
Asset Consulting Group. "An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns," (January 2012). Available at http://bit.ly/ACG-op-sell

Asset Consulting Group. "Key Tools for Hedging and Tail Risk Management," (February 2012). Available at http://bit.ly/TailRskACG.

Callan Associates. "An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy," (October 2006). Available at http://bit.ly/BXM-Call

Cambridge Associates, LLC. "Highlights from the Benefits of Selling Volatility," (2011). Available at http://bit.ly/CambridgeA-Selling

Chapman, Peter. "Pensions Eye Buy-Writes." Traders Magazine (December 2011).

Demos, Telis. "Income-generating Funds Find Favour," Financial Times (January 9, 2012).

EnnisKnupp & Associates. "Evaluating the Performance Characteristics of the CBOE S&P 500 PutWrite Index" (December 2008). Available at http://bit.ly/PUT-Enn.

Feldman, Barry et al. "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index," The Journal of Investing (Summer 2005).

Fund Evaluation Group. "Evaluation of BuyWrite and Volatility Indexes: Using the CBOE DJIA BuyWrite Index (BXD) and the CBOE DJIA Volatility Index (VXD) for Asset 
Allocation and Diversification Purposes," (2007). Available at http://bit.ly/BXD-FEG.

Hewitt EnnisKnupp. "The CBOE S&P 500 BuyWrite Index (BXM) – A Review of Performance (2012)," Available at http://bit.ly/HewittEK-BXM

Hill, Joanne et al. "Finding Alpha via Covered Index 2006), Financial Analysts Journal (September.-October2006), pp. 29-46.

Hough, Jack. "Options for Nervous Investors." Wall Street Journal (Dec. 10, 2011).

Moran, Matthew. "Record-High Correlations Pose Challenges For Modern Portfolio Theory," The Journal of Indexes (January-February 2010).

———. "Risk-adjusted Performance for Derivatives-based Indexes – Tools to Help Stabilize Returns." The Journal of Indexes (Fourth Quarter, 2002).

Russell Investments. "Capturing the Volatility Premium through Call Overwriting," (July 2012). Available at http://bit.ly/Russell-Buy-Write

Schneeweis, Thomas et al. "The Benefits of Index Option-Based Strategies for Institutional Portfolios," The Journal of Alternative Investments (Spring 2001), pp. 44-52.

Sears, Steven. "Buy-Write Is the Right Buy," Barron’s (Dec. 31, 2011).

Szado, Edward. "VIX Futures and Options: A Case Study of Portfolio Diversification During the 2008 Financial Crisis." The Journal of Alternative Investments (Fall 2009), pp. 68-85.

Ungar, Jason et al. "The Cash-secured PutWrite Strategy and Performance of Related Benchmark Indexes." The Journal of Alternative Investments (Spring 2009).

Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index" The Journal of Derivatives (Winter 2002), pp. 35-42.

Disclosures
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (the "ODD"). The ODD and supporting documentation for claims, comparisons, statistics or other technical data in this article are available by calling 1-888-OPTIONS, contacting CBOE at www.cboe.com/ Contact, or by visiting www.cboe.com/ The CBOE S&P 500 BuyWrite Index (BXMSM), BXY Index, CLL Index and PUT Index (the "Indexes") are designed to represent proposed hypothetical strategies. Like many passive benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. Transaction costs and taxes for an option-based strategy could be significantly higher than transaction costs for a passive strategy of buying-and-holding stocks. Investors attempting to replicate the Indexes should discuss with their brokers possible timing and liquidity issues. Past performance does not guarantee future results. Investors should consult their tax advisor as to how taxes affect the outcome of contemplated options transactions. The information in this article is not intended and should not be construed to constitute investment advice or recommendations to purchase or sell securities. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice.

Endnotes

1. Malkiel, Burton. "What Does the Prudent Investor Do Now?" Wall Street Journal (March 22, 2012).
2. Wirz, Matt. "As Corporate-Bond Yields Sink, Risks for Investors Rise." www.wsj.com (Aug. 14, 2012).
3. 29 U.S. Code Section 1104.
4. Highlights of GAO-12-324 "Recent Developments Highlight Challenges of Hedge Fund and Private Equity Investing," (February 2012) (available at http://www.gao.gov assets/590/588624.pdf).
5. Williamson, Christine. "Endowment Execs Focus on Liquidity, Volatility in Post-crisis Market," Pensions & Investments Online (March 7, 2011).
6. Please see www.cboe.com/benchmarks for more details and studies on the BXM, BXY, CLL and PUT indexes.
7. See, e.g., Asset Consulting Group. "An Analysis of Index Option Writing for Liquid Enhanced Risk-Adjusted Returns," (January 2012); Callan Associates. "An Historical Evaluation of the CBOE S&P 500 BuyWrite Index Strategy," (October 2006); Feldman et al. "Passive Options-Based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index," The Journal of Investing, (Summer 2005); Hewitt EnnisKnupp. "The CBOE S&P 500 BuyWrite Index (BXM) – A Review of Performance," (2012); Hill, Joanne et al. "Finding Alpha via Covered Index Writing," Financial Analysts Journal, (September-October 2006), pp. 29-46; Russell Investments. "Capturing the Volatility Premium through Call Overwriting," (July 2012); Schneeweis et al. "The Benefits of Index Option-Based Strategies for Institutional Portfolios," The Journal of Alternative Investments, (Spring 2001), pp. 44-52.
8. Whaley, Robert. "Risk and Return of the CBOE BuyWrite Monthly Index," The Journal of Derivatives (Winter 2002) pp. 35-42.
9. See the February 2012 paper by Asset Consulting Group for more details about the indexes and tail-risk management.

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