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.