Journal Papers

Option Writing Strategies in a Low Volatility Framework

By Jason Hsu Donald X. He Neil Rue

SEPTEMBER 2015 Read Time: 30 min

Executive Summary
The authors’ objective in undertaking the research they describe in this paper is to determine if a low-volatility strategy based on buy–write, or covered call writing, strategies have sufficiently different risk characteristics from stock-only low-volatility strategies. This is the first instance in which a low-volatility investing study looks at buy–write strategies.

He, Hsu, and Rue compare the performance and the risk–return profiles of three at-the-money (ATM) buy–write strategies with the buy-and-hold return of the S&P 500 Index over the 17-year period from February 1996 to December 2012. This period encompasses a variety of market environments. Analyses are performed using both gross and net transactions cost data. The covered call strategies analyzed are 1) three-month-to-maturity monthly rebalanced (3mo-1mo); 2) one-month-to-maturity monthly rebalanced (1mo-1mo); and 3) three-month-to-maturity quarterly rebalanced (3mo-3mo). 

The empirically supported low-volatility anomaly is often attributed to two behavioral finance hypotheses. The first is investors’ preference for lottery-like gambles. This explanation refers to the tendency of individuals to speculate in stocks with high volatility, particularly those with high positive skewness. The second is that investors who face borrowing constraints choose high-beta stocks as a means of increasing the risk–return profile of their portfolios. In both cases, the demand for high-vol stocks is raised relative to the demand for low-vol stocks, creating an opportunity to buy low-vol stocks at attractive prices. The same intuition would appear to apply to options as well. Call options are often purchased by speculators to lever up their bet and to provide a very positively skewed payoff. This suggests that the two distinctively different low-volatility strategies could actually be connected to the same behavioral bias.

The covered call strategy that forms the basis of the study is a long investment in the S&P 500 Cash Index on which S&P 500 call options are sold. This is constructed similarly to the BXM Index on the Chicago Board Options Exchange (CBOE). Data are from the CBOE OptionMetrics Database. European-style options are studied, and five different strikes are used: from 5% in the money to 5% out of the money at 2.5% increments. 

The authors find that the 3mo-1mo buy–write strategy outperformed the other two buy–write strategies on a risk-adjusted basis with a Sharpe ratio of 0.57 compared to 0.30 for the 1mo-1mo strategy and 0.18 for the 3mo-3mo strategy. The Sharpe ratio of the S&P 500 over the same period is 0.13. Contributing to the outperformance of the 3mo-1mo strategy were the longer-dated option’s monthly availability and greater liquidity as well as increased premium income from more frequent rebalancing, which created a cushion to absorb large drawdowns. The 1mo-1mo strategy outperformed the 3mo-3mo strategy, because its relatively more frequent rebalancing (one month versus three months) generated higher premium income. 

Over the study period, the five different strikes of the 3mo-1mo buy–write strategy produced Sharpe ratios ranging from 0.40 to 0.65. The three leading low-vol strategies (minimum variance, low volatility, and low beta) produced Sharpe ratios ranging from 0.53 to 0.58. The buy–write strategies, like the low-vol strategies, were less volatile than the S&P 500, having average standard deviations of 9% and 12%, respectively, compared to the benchmark’s standard deviation of 16%. 

The higher Sharpe ratios of the buy–write strategies are not solely a function of lower volatility, but also of higher long-term return. Both low-vol equity strategies and buy–write strategies have higher compound returns than the S&P 500. Both types of strategies benefit from lower maximum drawdowns (an average −25% and −36%, respectively, versus −52%) and less negative minimum monthly returns (an average −12% and −13%, respectively, versus almost −17%) than the benchmark. Because bear market meltdowns are more frequent than raging bull markets, the downside protection is a true value add in terms of long-term compound return. 

A comparison of the low-vol equity strategies with the buy–write strategies shows that the latter’s lower volatility, smaller minimum monthly returns, and lower maximum drawdowns pairs with higher negative skew, which ranged from −0.80 to −1.05. The negative skew was driven more by a minimally positive tail than by a long negative tail. The low-vol equity strategies’ negative skew ranged from −0.47 to −0.80, comparable to that of the S&P 500 at −0.76.

The authors find that the buy–write strategies’ risk-adjusted performance was earned from a combination of a skewness premium, paid to the option writers for assuming the tail risk of potentially unlimited loss, and the reduction in volatility from the hedge of the buy-and-hold security’s beta exposure. Effectively, covered call writers are selling options that are positively skewed “lottery” securities to market speculators. 

To compare the performance of the buy–write strategy and the low-vol strategies, the authors use an augmented Fama–French–Carhart four-factor model (FFC-4), adding the betting-against-beta (BAB) factor and duration. In this analysis, the 3mo-1mo strategy produced economically large and statistically significant factor-adjusted alpha of 3.42% over the study period (February 1996–December 2012). The option writing strategies, unlike the low-vol strategies, do not load on either the BAB or value factors, indicating that the buy–write strategies and low-vol strategies can be blended together to gain meaningful diversification benefits for investors seeking low-volatility solutions. 

The attribution analysis goes one step further by dividing the return of the covered call portfolio into four categories: market risk (S&P 500 and delta return), lottery risk (theta and gamma return), ex ante volatility risk (vega return), and other option risks. The results of this analysis also support the earlier findings of a risk–return profile consistent with the hypothesis of investors’ demand for lottery-like gambles.  

The encouraging news for low-volatility investors is that buy–write strategies offer an uncorrelated source of return and a risk-diversifying addition to their portfolios. Not only does covered call writing (especially the 3mo-1mo strategy) earn a higher return versus the buy-and-hold index portfolio, but it benefits from lower volatility than the index. The improvement in return results from the skewness premium received by the option writer in exchange for assuming large negative tail risk, which is a function of the preference-for-lottery hypothesis, likely a foundation of the low-volatility anomaly.

Summarized by Kay Jaitly, CFA.

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