Writing covered calls

Having a diversified portfolio is critical for any investor to be able to draw good returns on his investment. Every investor likes to keep a mix of stocks in his portfolio, with some stocks which are less volatile and at the same time offer good risk adjusted return. Keeping this need in mind we discuss here Buy write strategy as part of investor’s portfolio to bring diversification and stability in the portfolio.

Low vola combined with written options

A study conducted by Mr. Donald X, Mr. Jason and Mr. Neil Rue released in the form of research paper titled “Option writing strategies in a low volatility framework” analyses returns of buy strike strategy, their risk characteristics and return that could be generated by examining the returns from call options from S&P 500 index over the span of 17 years. The purpose of the research was to analyze whether it is possible for a low volatility investor to exercise diversification in his portfolio by introducing buy write options. The study then goes on to establish that it is a good strategy to include buy write options in order to bring variety and mixture in the portfolio and improve risk adjusted return.

Lower vola through written call options

It was concluded that risk return profiles of buy write strategy is very similar to that of low volatility equity portfolios i.e. portfolios with low beta. In their study, returns of three buy write portfolios and S&P 500 were compared starting from 31 January 1996 till 31 December 2012. It was discovered that three month monthly rebalanced strategy (3mo-1mo) outperforms S&P 500, three-month three monthly (3mo-3mo) and one-monthly monthly rebalanced strategy (1mo-mo) by huge margin. Further, it was seen that 3mo-3mo just manages to match returns of S&P 500 and does not perform as good as other buy write strategy. As per returns that 3mo-1mo strategy offered to its investor, it is the best buy write strategy mainly due to its availability at monthly frequency and then option of rebalancing due to availability which is not the case in other long dated option as other long dated options are not created on monthly frequency. Important thing to note here is that monthly rebalancing is crucial in order to extract higher return unlike conventional strategy of buy and hold till maturity strategy of writing call options.

Downside protection via received premiums

The common factor among all the 3 buy write strategies is that they produce lower volatility and drawdown against S&P 500, which is exactly the case with low equity volatility portfolios. In a market position where sharp fall in market is normally more significant than sharp rise in market index, investor would prefer buy write strategy which offer substantial downside protection at the cost of relatively lesser sacrifice during the rise in market index. This is where it gets crucial for investors, in case of significant corrections in the market or bubble burst, an investor with buy write strategy would suffer comparatively lesser loss as compared to the drop in market as a whole and would benefit from variety / diversification in his portfolio. The study also compares the return of 3mo-1mo buy write strategy against S&P 500 in down market, and it was seen that 3mo-1mo offers higher return than S&P 500 in the down market.

Options deliver diversification advantage

To summarize, the research exhibits that having (3mo-1mo) 3 month buy write options with monthly rebalancing in the portfolio is an optimum way to bring diversification in the portfolio and at the same time achieve a higher risk based return for investors looking for low volatility investment as compared to buy and hold strategy. Further, in case of economic meltdown or market fall, this diversification would offer stability to investor as chances are that they would suffer comparatively lower amount of loss as compared to the market as a whole if we create an expectation on the basis of past trend.