Sunday, December 10, 2006

CBOE S&P 500 Buy-Write Index

The Chicago Board of Options Exchange (CBOE) has a benchmark index designed to track the performance of a hypothetical buy-write (covered call) strategy on the S&P 500 Index named the CBOE S&P 500 BuyWrite Index (BXM). Case studies were done by Ibbotson and Callan. These studies show that the returns on BXM vs the S&P were almost identical, however, on a risk adjusted basis the BXM outperformed the S&P.

The new Callan Associates study had several key findings, including:

  • BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk. (The compound annual return of the BXM was 11.77% compared to 11.67% for the S&P 500, and BXM returns were generated with a standard deviation of 9.29%, two-thirds of the 13.89% volatility of the S&P 500.)

  • The risk-adjusted performance, as measured by the monthly Stutzer Index over the 18-year period, was 0.20 for the BXM vs. 0.15 for the S&P 500. A comparison using the monthly Sharpe Ratio yielded similar results (0.22 vs. 0.16, respectively), confirming the relative efficiency of the BXM over the 219-month study period.

  • The BXM underperformed the S&P 500 during most rising equity markets and consistently outperformed the S&P 500 in all periods of declining equity markets, demonstrating the return cushion provided by income from writing the calls.

  • The BXM generates a return pattern different from that of the S&P 500, offering a source of potential diversification. The addition of the BXM to a diversified investor portfolio would have generated significant improvement in risk-adjusted performance over the past 18 years.

These studies indicate that by adding a buy-write (covered call) strategy to a portion of your portfolio you can reduce the overall volatility. As mentioned in my previous post, don't put all your eggs in one basket. While covered calls certainly have a place in your portfolio you should diversify by using other strategies and investment vehicles.