Practical analysis for investment professionals
27 January 2012

Write or Wrong: A Flat Market Doesn’t Mean Flat Returns

Posted In: Derivatives

The world is flat, or so people thought, until enterprising Greek philosophers challenged the notion in the 6th century BC. More than 2,000 years later, Ferdinand Magellan made a practical demonstration of that fact when he circumnavigated the globe. Although stocks in 2011 sailed through periods of sunshine, wind, and rain, many equities markets ended up flat just the same. Nonetheless, some investors proved that it is possible to make money in this market — and they did so writing covered calls.

Covered call writing is a strategy whereby the owner of a stock sells a call option that grants the right to have the stock “called away” at a certain price in the future. This strategy can also be done on many ETFs and indexes, as long as you hold an appropriate exposure to the underlying asset (the ETF or index).

Let’s take a look at how the strategy stacks up to my golden rule of options. This rule, learned the hard way, through two decades of profits and losses as a market maker on the options trading floor, consists of the following:

All option strategies have both positive and negative attributes. The key to using options successfully is to make sure the positive attributes are more valuable to you/your client than the negative attributes are detrimental.

This sounds like such a simple concept, but so many of us forget that for every buyer there must be a seller. If that is the case, there must be both positive and negative consequences to each trade. This is clear when buying a stock: the positive (making money as the stock price rises) is offset by the negative (suffering losses when the stock price falls). But this simple truth is often forgotten in the options markets due to the many moving parts, such as time decay, volatility changes, etc.

In the case of the covered call strategy, the positive is the premium you receive for selling the option. This premium may be large or small depending upon various factors, including the amount of time to expiration, the volatility of the underlying asset, and the option’s strike price compared to the price of the stock, ETF, or index. By the time of expiration, if the underlying asset remains below the strike price of the option, the premium is a positive collected by the option seller. (Don’t you dare think of this as a “free” dividend.) A negative occurs when, at the time of expiration, the underlying asset price has risen above the option’s strike price by more than the premium of the option. This is the positive and negative paradigm involved in covered call writing.

So now that we know that covered call writing often enhances returns but can also cap upside gains, how do we determine the past performance of such strategies? One way is to check out the BuyWrite Index (BXM), which shows how a passive options selling strategy on the S&P 500 index might have done. (Buy-write is another name for a covered call, because you buy the stock and write call options on it.) The index calculates a strategy that sells a one-month, at-the-money call option, waits for expiration (where the option is cashed out), and then sells another one-month, at-the-money option.

BXM Index

Sources: CBOE, Bloomberg.

During 2011 the BXM Index returned 5.7%. Not bad for a flat market. By selling covered call options, the time decay in the position enhanced the returns.

What happens in a rapidly rising market? Well chances are you will underperform with this strategy. Remember, there is both a positive and negative aspect to all of these positions. But, overall, the BXM and strategies like it have outperformed market indexes with lower variability of returns.

Want to know more about the BXM? Check out the great reports by Callan Associates, Ibbotson Associates, and others at the BXM website. The Options Industry Council also has insightful reports about covered call writing strategies, and a great audio recording from CFA Institute, “Managing Covered Call Option Positions,” will provide you with many useful insights.

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About the Author(s)
Bud Haslett, CFA

Bud Haslett, CFA, is executive director of the Research Foundation of CFA Institute and head of risk management and derivatives. Previously, he served as director of option analytics at Miller Tabak + Co., LLC, and as CEO of Miller Tabak Capital Management. Haslett also spent two decades on the options trading floor, where he managed portfolios of stocks and options. He also served as a board member of CFA Society New York, chair of the board of regents for the Financial Analysts Seminar, and president of the CFA Society Philadelphia. Haslett was an active volunteer for CFA Institute, having served in a variety of capacities, including as a CFA exam grader and member of the Council of Examiners. He has also taught coursework on options at New York University, Johns Hopkins University, and Rutgers. Haslett is the founding chairman of the derivatives committee for CFA Society New York and is a member of the Institutional Investor Advisory Committee for the Chicago Board Options Exchange. He has conducted option presentations and workshops at more than 50 CFA Institute societies. Haslett holds master’s degrees from the University of Pennsylvania and Drexel University, and he has earned the Financial Risk Manager designation. Topical Expertise: Derivatives · Risk Management

7 thoughts on “Write or Wrong: A Flat Market Doesn’t Mean Flat Returns”

  1. pawan choudhary says:

    Sir , this is really helpfull. but my main concern is that wen we are in bull market or trading at Above average P/E ,applying this strategy can ruin our portfolio.Had it been the case we would have applied this at Nikki Japanies index wen it was trading at 40k we would have faced huge losses.So market must nt be expensive if we are thinking to hedge our underlying by selling call ..Kindly suggest me ..

  2. Bud Haslett, CFA says:


    Thanks for your comments. You bring up a very important point (the downside risk inherent in the covered call position). This is a very real risk, but it is a risk that is also present in just owning stocks. I wrote the article from the perspective of examining your equity holdings from last year, many of which were unchanged, and suggesting that covered call writing might be something to consider if you would like to add returns during years when stock prices were flat. I highlighted the risks and rewards from the perspective of owning the stock by itself, with unlimited upside, to owning the covered call position with limited upside and a bit of possible return from the option premium sold.

    Although the covered call position will outperform a stock-only position in a downward price move, it does have almost as much risk on the downside so that is why I did not highlight that aspect. If you compared the covered call to say a fixed income investment, the additional downside risk of the covered call would be something that you would need to address.

    Thanks again for the great comment, and hope this explanation clears things up. If not, please post another comment and I will gladly respond…

    Bud Haslett, CFA

  3. Ugur Demir says:

    You bought the security, then you wrote a call option say for a month. Sold it with a premium. If the price gone up the counter party will exercise the option so you will remain with the premium. If the price went down the other party won’t exercise and you will have the premium and the security.
    According to this plan (100% coverage is assumed) you will not make a loss other then the loss from profit. But your gains will be limited with the premium. So the premium is important.
    Good way of getting some extra from your investment.
    But the option price shouldn’t be one that will be easily exercised I guess?

  4. Bud Haslett, CFA says:

    You have a couple different points in this comment Ugur so why don’t I address the one about early exercise.

    Just because the stock goes up and the option is now in-the-money doesn’t necessarily mean the option will get exercised right away. In-the-money options have two components to their premium, a time premium and intrinsic value. The intrinsic value is based upon how much the option would be worth if it were exercised today. For example a March 35 call with the stock trading at 36 would have an intrinsic value of $1 (36 – 35). However, if there is still time left until expiration, the option might be trading in the marketplace at $2 or $3. Why would you exercise the option and receive $1 when you could sell it in the marketplace for $2 or $3? In this case, the extra value of the option above the $1 intrinsic value is the time premium. So it is usually not optimal to exercise the option that has additional time premium (unless there is a dividend or corporate event coming – we can save this for another day).

    Another factor against someone exercising a call option early is that by doing so you are in reality selling a put… Initially, this may be a bit counterintuitive but let’s take a look. If you bought the March 35 call at $2 with the stock at 36, the most you would lose is $2 (the amount you paid for the option). Even if the stock goes to 0, if you are the owner of the call option at $2 that is the most you can lose. If you exercise the call option, you now own the stock. What happens if the stock goes to 0 now? By exercising the call option early you now have risk below 35 just like you would if you had sold the March 35 put.

    In my experience, clients get very nervous when their covered call position goes in-the-money (especially if it is low basis stock). But by carefully monitoring the position, and checking the amount of time premium left in the option, you can usually avoid early exercise situations and complete some adjustment strategies (such as rolling to another expiration or higher strike price) to avoid having the stock called away.

    Thanks again for your comments Ugur, and please let me know if you have any additional insights…

    Bud Haslett, CFA

    1. Ugur Demir says:

      Thanks Bud, for your reply. It was a great insight for me.

  5. Cheers much for that great report. I will be glad We’ve used some time to master this.

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