Call Premiums As A Source Of Return

Selling index options 12 times per year produces significant income. Whaley (2002) and Feldman and Roy (2005) demonstrated that implied volatility reflected in the price of S&P 500 options is often higher than realized volatility, suggesting that index calls trade at a persistent premium to their fair value.

The CBOE BXD call premiums, earned as a percentage of underlying value from October 17, 1997 to October 20, 2006, is plotted against the CBOE DJIA Volatility Index (VXD) (a measure of expected stock market volatility) in Exhibit 9.

The average monthly premium since October 1997 is 1.84%, an annualized rate of 24.46%. Premium levels are closely tied to volatility expectations; premiums rose sharply with volatility in the bull market of the late 1990s and through the sharp market decline in 2000-2002. Both premiums and expected volatility have since subsided to the levels observed in the early 1990s.

Exhibit 10: The risk and return characteristics of various portfolios is shown above. Incorporating the BXD into these portfolios would have improved risk adjusted returns (Sharpe ratio).

Exhibit 11: The graph above illustrates the trade-off of allocating assets from one investment to the other. The combination of the two assets provided superior returns for each level of risk.

Can Long Volatility Futures Smooth Portfolio Returns?

Recall from Exhibit 9 that the CBOE DJIA Volatility Index (VXD) has tracked closely with call option premium prices. Option price premiums have increased substantially during stock market declines as evidenced by the large average VXD advance corresponding with large DJIA average declines (Exhibit 13). However, the VXD did not decline with the same magnitude during large stock market advances.

The VXD and the Dow Jones Industrial Average were inversely correlated (-0.62) over the course of this study, but the larger VXD advances during market declines indicate that it has been more reactive to stock market declines than stock market advances.

Exhibit 13: Option price premiums have increased substantially during stock market declines as evidenced by the large average VXD advance corresponding with large DJIA average declines.

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