Stocks quoted in this article:
Selling volatility sounds like it adds risk to your portfolio, right? Well, not so much, according to the Chicago Board Options Exchange (CBOE). They've created a whole stable of benchmark indices over the years, many of which you can find here.
Here's an interesting look at a few of them -- CBOE S&P 500 BuyWrite Index (BXM), CBOE S&P 500 2% OTM BuyWrite Index (BXY), and CBOE S&P 500 PutWrite Index (PUT). BXM is a buy-write index that buys S&P 500 Index (SPX) and sells at-the-money (ATM) options one month out, then maintains the position for one month and rolls into ATMs on the next monthly cycle. BXY is the same as BXM, except it sells options that are 2% above the money. PUT is, well, similar to BXM and BXY, but I'll let CBOE describe it.
The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.
Anyway, here's how they've done over the last 25 years, per CBOE.
So, BXY and PUT have better returns than SPX, and all three have lower volatility. Sounds like a win-win! It also sounds counter-intuitive. Selling volatility reduces volatility?
Well, in this case, yes it does. Think about a buy-write vs. straight stock ownership. It underperforms on the upside in that it caps gains. That's especially true in this particular buy-write strategy. If SPX lifts early in the cycle, for example, the premiums on the calls BXM writes go close to zero and you effectively have no position on. You miss out on any further gains.
On the flip side, all these indices will lose less on a market decline (yes, those happen too). You still lose, but at least you take in some premiums to mitigate the losses. So yes, it does make sense that the standard deviation of the returns would be lower.
Now, there are a couple things to keep in mind here. These are just benchmarks, not actual tradable products. Of course, you can replicate it -- or buy a fund that replicates it. And, you can probably improve on the results by being more flexible with the timing of the rolls. On a "live" buy-write portfolio, it would make more sense to roll out once the options get to either a particularly high or particularly low delta. If the options are near either 100 or 0 delta, they turn your position into effectively either all-cash or all-stock.
Before you go and reallocate your portfolio, it's important to note that those CBOE numbers cover 25 years, and a lot of the benefit of the premium-selling strategy accrued during uglier markets. We'll break it down a bit in the next few days.
Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.