Understanding The VIXC

If you spend a little time surfing around the Montreal Exchange site you will eventually make your way to the MX Indices tab. At the top of the menu you will find a link to the VIXC, which is the S&P/TSX 60 VIX or volatility index. The VIXC reflects the 30 day implied volatility of S&P/TSX 60 front month and next month options. Implied volatility is the component of the options price that reflects expected or anticipated movement in the underlying security.  If a stock or an index is expected to trade with in a predictable range, implied volatility or IV tends to remain low. However, when there is an expectation of uncertainty or an element of risk introduced to the market, IV will increase.  I try to explain it like car insurance premiums.  If you fall into a low risk category and have a history of safe driving, your car insurance premium is low.  If you fall into a more risky category or perhaps land yourself a speeding ticket, even though you have yet to get into an accident your insurance premium will increase.  This is the insurance companies way of hedging against the possibility or probability of an accident.

If we think of option premiums in a similar way, it becomes a little easier to understand why the VIXC has negative correlations to the underlying market.  As the S&P/TSX 60 begins to show signs of weakness or there is a broader market concern for risk, S&P/TSX 60 options, also known as SXO options, will be priced higher to compensate the option writer for the uncertainty.

Below is a snap shot of the VIXC.  Note that the S&P/TSX 60 Index is in the red and a measure of the implied volatility of SXO options is represented in blue.  You should be able to see the negative correlation clearly.

vixc

It is important to realize that each stock and their associated options will have their own comparative measure of implied volatility.  The VIXC provides us with a good indication of market conditions in general, however we still must pay attention to the relationship between the historical volatility and implied volatility of individual stocks.  This is due to the unique risks associated with certain companies that are not necessarily reflected in a market index.

With that in mind, we can use the VIXC to help us determine which strategies might be more effective based on the market conditions.  For example, when the VIXC is in the low area of the range between 8.5 and 10, this represents a period of overall low implied volatility and options may be considered undervalued or fairly priced.  This is a good time to be an option buyer from a pricing perspective. Keep in mind that this doesn’t mean you will necessarily be correct about your outlook, just that you have a reduced risk of loss due to a contraction of implied volatility. In addition, a closer look at the chart suggests that when the VIXC is at its lowest and the index is at it’s highest a market pull back may soon follow.  I look at this as a sign of complacency in the market and a good time to consider buying protective puts or locking in some profits ahead of a potential sell off.

When the VIXC is in the high area of the range between 14 and 16, this suggests implied volatility is high and options may be considered expensive.  During this period, option writers can collect a higher premium due to market uncertainty. In addition, traders who are considering taking a directional stance using options may consider using debit spreads as a way to offset the increased implied volatility.

Currently, the VIXC sits in the middle.  This suggests option premiums are pricing in some risk and investors should consider this when looking to take a bullish stance on the market. Protective puts, collars and spreads are good considerations in this market environment. Close attention should be paid to the implied vs. historic volatility of individual stocks to ensure that the correct strategy is being used based on the observations.

Taper and the Unintended Consequences

Download Richard Croft’s informative presentation Taper and the Unintended Consequences from the recent Options Education Day in Vancouver

The Yellen Message!

The markets have been tepid lately as investors watch for signs of an improving US economy, a message telegraphed by Fed Chairman Yellen in her first news conference a couple of weeks ago.

If the data come in as Yellen expects – or more importantly as analysts think Yellen will interpret the data - traders may have to readjust valuations to match up with real economic activity rather than liquidity-induced euphoria. And while that can be a good thing, there will be a period of adjustment.

If the economy is really improving, as posited by Yellen, then the Fed will pick up the speed at which it ratchets down their bond purchase program (i.e. QE III).  The markets will have to deal with an anticipated rise in interest rates, which would be bad for bonds and every other segment of society. That logic probably explains the trading range mentality of the financial markets over the past couple of weeks.

Some Fed watchers think that Yellen’s comments - notwithstanding the back peddling that went on after the fact – imply that short term rates could rise sooner than expected. That is sooner than the second half of 2015 timeline that most economists had been using to build out their GDP forecasts. But does that really matter?

Is there a scenario where QE-III ends, short-term rates rise yet medium and longer-term rates remain in check? Difficult to imagine unless you consider demographics! Is it possible that yield-hungry baby boomers will cause distortions along the yield curve in much the same way as the Fed has been doing for the past five years?

Consider the statistics that tell us baby boomers control about 70% of the wealth in North America. These same baby boomers are keenly interested in how much income they can generate from their portfolio rather than how fast they can grow their portfolio. I suspect in a rising interest rate environment baby boomers would be buyers of medium and longer-term bonds which may cap any surge in rates along that spectrum of the yield curve.

Imagine an economy where there is stability in medium and longer-term rates! Without interference from central banks, investors would have to focus on real economic activity. Low interest loans would be easier to come by for young consumers who have been working hard for the last five years repairing their balance sheets. Imagine the possibility for growth if US banks start loaning out some of that US $2.4 trillion in excess reserves that has been sitting on their balance sheets, the result of three different quantitative easing programs.

When real liquidity gets pumped into the real economy it will cause a tsunami of economic activity, probably at a time when investors are most fearful! Financial markets will surge from the ripple effect of unexpected economic growth, eventually reaching heights that will no longer be sustainable, but just high enough to entice smaller investors back into the markets after most of the gains have been made. I’m just saying!

If you can excuse the veracity of my message from the pulpit, allow me to offer a benediction. I simply do not believe that rising short-term rates will lead to a major crack in the economy. And while we may see a short term knee-jerk reaction in the financial markets… sentiment being what it is, I suspect it will be no more than a minor correction in an otherwise longer term bull market.

Using Options as a Tax Deferral Strategy

Over the last 2 days I have had the opportunity to speak at the Options Conference in Toronto and Montreal.  The conference brought together the top industry professionals from across North America with a focus on the use of options for Investment Advisors and Portfolio Managers.  It was a phenomenal opportunity to hear some the great investment minds discuss the different approaches to adding value to their clients through using options.  In particular, it was interesting to note how these managers differentiate themselves in a sea of competition.

During my 2 hour presentation, I had the opportunity to cover many different strategies professionals could utilize, but I wanted to further elaborate on the strategy of using an options collar as a tax deferral strategy.

For those unfamiliar with the strategy, it involves the buying of a put and the selling of a covered call against a stock you or your client already own.  For any need to seek tax deferral, the stock position needs to meet some basic criteria:

  1. You or your clients are making considerable capital gains on a stock or ETF.
  2. You or your clients are looking to take the profit.
  3. From a time frame perspective, it is later in the tax year and there is growing incentive to delay the sale for tax purposes.

To use an example, the investor purchased shares of XYZ Financial at $20.00 a share.  Over the next 6 months the stock proceeds to rally to $40.00 into November of that year. This price move exceeded analyst targets and the valuations are becoming expensive from a historical perspective.  Instinctively, the investor is inclined to want to just sell the shares, but would incur the tax disposition in the current calendar year.

Alternatively, the investor could simply hold into the New Year to defer the tax disposition, but risks that the stock could considerably reverse and the investor would miss the window of opportunity to have sold.

So how would an investor build an options strategy to defer the sale into the next tax year, but at the same time secure the price at these higher levels?  Using the collar, it would involve the buying of a multi-month protective put, in this example the investor picks the January $38.00 put for $0.35 or $35.00 for every 100 shares.  The second leg of the strategy involves selling a covered call for a premium income. In this example, the investor picks the January $42.00 call, which is bidding $0.22 or $22.00 for every 100 shares.  What the investor has created is a hedge wrap with little to almost no significant cost ($0.13 net). At the same time, the investor can now comfortably wait the several months to sell the shares in the new tax year. The collar has secured a worst case scenario sale at $38.00 and a best case scenario of a sell at $42.00.

The consideration for investors is that most call options are American style, which means in theory the $42.00 covered call can be exercised before the new calendar year.  While always a risk, it can be considerably diminished by simply observing the x-dividend day and if the call option is in-the-money prior to the dividend payment. In that circumstance, the investor can close or roll the covered call to another strike to manage that risk.

If you are investment advisor or portfolio manager in the Vancouver area and would like to learn more, the Options Conference is on April 3rd at the Fairmont Pacific Rim.   Use this link to learn more.

Options Action on Bombardier

From time to time I like to take a look at the “Most Active Options” ranking on the Montreal Exchange home page. It was no surprise to see that 6 out of the 10 were mining companies this morning.  Since Richard Croft already posted and interesting article on this sector the other day entitled Gold, Where’s the Glitter, I decided to take a look at a few of the other stocks.

Bomardier (TSX:BBD.B) trading at $3.90 caught my attention, and upon review of the chart it appears to be a potential bullish opportunity.

Bomardier (TSX:BBD.B) WEEKLY CHART

BBD.B March 14 2014

With that in mind, I took a look at the option chain to determine just where all of the action was taking place.  Today, there was some unusual activity on the April $4.00 strike puts. As I have outlined in previous blogs, it is difficult to determine just what the rationale is behind the increased volume.  Knowing if it  was an opening transaction, closing transaction, a buy or a sell would help us determine the objectives of the trader.

Since we can’t make that determination, I am going make an assumption that this was an In-The-Money Put Write.  The put option is determined to be In-The-Money since the stock is currently below the strike of the put option contract. With the stock currently trading at $3.90, the $4.00 strike, April Put would have an intrinsic value of $0.10.  The bid on this option is $0.19.

The question is, why would anyone sell an  In-The-Money put?  Remember that the put option writer is paid a premium to take on an obligation to buy the shares at the strike price selected.  This obligation is only valid if the shares are trading below the strike price and it’s enforceable until the close of the market on the third Friday of the expiration month selected.

In this case, if the investor was looking to generate cash flow, but was ultimately ok with owning the shares at $4.00 if assigned, the put option write would satisfy this objective. If the Bombardier shares are trading above $4.00 at expiration, the investor keeps the premium. This would represent an approximate 1.8% return for the time period or an annualized rate of return of almost 20%.

If the shares remain below the $4.00 strike, the investor would be assigned to take ownership of the shares at $4.00.  The premium collected from the put write is the investors to keep.  This lowers the average cost base down to $3.81. Once the shares are in the investors account, the Covered Call strategy may be implemented to further enhance returns, in addition a modest 2.6% dividend will be collected.

The risk is if the shares have significantly dropped in value.  While the average cost base and subsequent break even point have been reduced, the investor can experience unidentifiable losses as the share price drops below their break even point.

Some Considerations

  • The Put Write has the same risk/reward profile as the Covered Call
  • The investor must have sufficient enough capital to meet margin requirements
  • The Put Write strategy is not permissible in RRSP and TFSA accounts
As I mentioned, I am only speculating on the potential objective behind the trade.  However, it is a reasonable assumption that an investor focused on generating income, with a bullish outlook on the stock would use the Put Write as an approach to get “paid” to buy shares of a company that they are considering owning.

Gold: Where’s the Glitter?

For gold aficionados, it has been a rough eighteen months. Even diehard doomsayers who see gold as crisis insurance have been asking; “where’s the glitter”?

From my perspective, I have never been a gold buff and have never believed it was reasonable to view gold as portfolio insurance. So, we are left with short-term trading opportunities among gold mining stocks where traders try to capture emotionally induced rallies interspersed with sharp sell-offs. Fear and greed play such an important role within this sector!

Because gold stocks consistently display above-average intraday volatility, they do make for interesting covered call candidates. A study I did in the 1990s examined the sale of short term at-the-money calls against a number of gold stocks. Over a ten year period, the covered call strategy produced two to four times the return when measured against a buy and hold strategy for the same stocks. Suggesting that writing covered calls on gold stocks was an excellent strategy to consistently produce alpha.

Seems counter-intuitive to gold buffs, who argue that gold has generated substantial returns since the turn of the century, outperforming most other sectors by a sizeable amount. At least that was the case until the past eighteen months.

In reality, most gold stocks – accepting that some stocks within this sector get taken out to the woodshed because of some unique non-systemic risks (i.e. Barrick Gold being a case in point) – tend to trade within a range and the options market does a decent job of predicting what range is reasonable.

Recent momentum has provided some decent rallies within this sector, which on the surface suggests that gold stocks may have seen their bottoms. Non-systemic risks aside!

If that is the case, then it may be a good time to consider a covered call or naked put strategy. Selling covered calls strategy as an income generating strategy within registered plans. Using the sale of naked put options to take possession of specific gold stocks at lower prices, all the while taking advantage of above average option premiums!

With that in mind, you might want to look at Franco Nevada (Listed on the TSX, symbol: $56.59). You could write, say, the April 58 calls at $2.10. The two month return if exercised is 6.015%, while the return if unchanged is 3.71%.

For the naked put strategy, consider writing the Goldcorp (symbol G, $29.77) July 28 puts at $1.60. If the stock stays the same or rises you will retain the premium from the sale of the naked put. That is your maximum potential return. If the stock declines you will purchase the shares at a net cost of $26.40, which is calculated as the strike price less the premium received. With this strategy, you should be comfortable holding the shares at that price.

Fundamental and Technical Analysis for Options Trading

Fundamental analysis remains the most commonly utilized investment tool available. Through its use, investors seek to filter out the strongest, or best, valued companies in the market. There is no question about the value of utilizing fundamentals, but it does present the investor with an obstacle.  There is a distinct disconnect between balance sheet analysis and the high paced action of the live markets.

“Over the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).” Benjamin Graham

This best describes the dilemma.  No matter how good the value and fundamentals are, the market will not reflect the value in the price until all investors recognize the value (the herd is the voting machine). While there are many people beating the fundamentals drum, they rarely emphasize the psychological fortitude that investors must endure to see through a value investment or fundamental outlook.

The psychology in investing is a powerful force. More importantly, many retail investors tend to invest money that they cannot or do not wish to risk.  In many cases, even if fundamentals would prevail over a longer time horizon, many investors that cannot stomach watching their investments decline succumb to selling to stop the pain.

There are two alternative solutions:

1. Develop the psychological fortitude needed to be a long term value style investor.

2. Identify the stocks that you fundamentally want to own and utilize technical analysis in an attempt to identify when a new uptrend could potentially be underway to attempt to diminish the risk being caught on the wrong side of a trend.

We are big advocates of applying technical analysis to fundamental and value based stories in attempts to identify key turning points in trend. The shortcoming of this approach is that the technicals are attempting to time the ambiguous “voting machine” part of the market.  This is where options as an investment tool can be utilized.

Options represent a defined certainty, one that the stock market alone cannot give. The most basic example is the protective put strategy. If the investor has both fundamental and technical reason to buy, the investor could simply buy a short-term put protection to fix a guaranteed exit price (if the technical trend fails).  The put represents an insurance policy, and more importantly, a psychological floor for risk.  To learn more about using puts as protection, investors can watch many great free educational videos on the www.m-x.tv site.

Those of you that are interested in learning more on this topic, I am going to be in Vancouver April 5th to speak at the Options Education Day at the Fairmont Pacific Rim Hotel. I will be presenting a more advanced look at Fundamental and Technical Analysis for Options Trading. Other great speakers like Jason Ayres, Peter Lusk from the OIC and Richard Croft will be there. I am particularly interested to hear Richard discuss the “The Unintended Consequences of Tapering”.  Click this link to learn more.

Blackberry Resuscitated?

It’s not often you see a company rally despite declining earnings, especially a company that is in the process of overhauling its business model! Nonetheless, that that is exactly what is happening with Blackberry under the guidance of recently appointed CEO John Chen.

Blackberry continues to fall short on earnings no matter how much management tries to manage expectations, and that is likely to continue for at least the next few quarters. Fortunately for Mr. Chen that does not seem to be impacting its’ share price as investors are no longer judging the company on its hardware business. The current focus is on Blackberry’s BBM mobile messaging software.

The company is trying to rebrand itself as a developer of messaging apps for the Android and iPhone markets. Its’ latest and most intriguing apps are the BBM Voice, BBM Channels and BBM voice notes.

The objective is to engage users to share content via BBM as a VoIP (voice over internet protocol) service. If there is a successful uptake by users, then Blackberry can turn its attention to monetizing the service. At this stage, Mr. Chen is getting a pass as he tries to guide a much leaner company through uncharted territory.

The company’s shift has attracted the attention of some large players, most notably activist investor Dan Loeb, who manages the Third Point LLC hedge fund. Like the rest of the market, he is giving the company some wiggle room but eventually will probably want management to spin off BBM as a separate company.

Complicating matters was the recent resignation of Andrew Bocking, who was the executive in charge of BlackBerry’s BBM. That may have been late stage housekeeping, as Mr. Bocking was a key player under the Thorsten Heins administration. Like most new leaders, Mr. Chen will want to put into key positions his own team, but it does raise the level of uncertainty which may well shorten Blackberry’s honeymoon period.

In my mind, this is a last gasp from a great Canadian company. I hope it works, but a lot of things will have to fall into place before shareholders will see any real profits from this division. At some point, BBM will have to produce real earnings or the momentum that is currently driving up the shares will be lost.

If you want to bet on BBM you can buy the stock, but given the real possibility that the company will not produce much in the way of earnings for the next few quarters, you would be buying on the basis that the market will continue to cut the company some slack.

As such, you might think about writing covered calls as the premium on Blackberry options are in the top quartile of all Canadian options. At least you can generate some cash flow while you wait for the BBM saga to unfold.

Generate Cash Flow with Less Capital - Consider Credit Spreads

Many investors seek to enhance cash flow in their portfolios.  For the option educated, this can involve the implementation of the Covered Call strategy or selling Naked Calls or Naked Puts.  The objective is to collect a credit through the sale of an option contract with the expectation that it will expire worthless. This can occur if the underlying stays the same or moves in a direction that places the written contract Out-Of-The-Money.

A Quick Review

Call Writer - Paid a premium/collects a credit and is obligated to deliver shares at the written strike
Put Writer - Paid a premium/collects a credit and is obligated to buy shares at the written strike

For the Covered Call writer, the obligation to deliver the shares at the written strike is “covered” by the ownership of the underlying shares.  The investor incurs a loss as the shares drop in value below the purchase price, less the credit.

For the Naked option writer, the risk is also unidentifiable.  As a result, the broker will require the Investor to have sufficient enough capital in their account to cover the obligation.  For the record, I am by no means suggesting that these approaches don’t have a place in an options oriented portfolio. In fact, I believe that the Covered Call strategy is a powerful approach to enhancing yield in a portfolio.  I also believe that writing puts on shares that you want to own, at levels that you want to own them has its place as well.

The common consideration for the Covered Call, Naked Call and Naked Put is that in all three scenarios, the investor is required to have sufficient enough capital or margin available to maintain the position.  Further to that, the credit received for the sale of the option is limited, while the risk on the position is undefined.

To limit the amount of capital required to implement an option writing strategy we can create a Credit Spread.  Credit Spreads involve the sale of an option at a strike that is close to the current share price of the underlying and the simultaneous purchase of an option at a strike further out.

To Simplify

Sell the expensive option = collect a credit
Buy the further out “cheaper” option = incur a debit

Net result = Credit

Maximum risk = Difference between the strike prices minus the net credit
Maximum profit = Net credit

The typical approach to this strategy is to sell options that are Out-Of The-Money. The expectation is that as long as the option is written at a level where the stock is not likely to trade with in the time frame, the contracts will expire worthless and the net credit will be realized at expiration.

This strategy can be implemented using calls and puts, however for the sake of this post, we will take a look at a Bull Put Credit Spread.

Out-of the-Money Put Credit Spread - Agrium (TSX:AGU)

Since option prices are based on probabilities, the further Out-Of The-Money the written strike is, the higher the probability that it will expire worthless.  The challenge is that the credit received for the spread is significantly less than the risk.  This means that you can be right several times over, but the one time that you are wrong and the stock moves greater than expected, the profits from many successful spreads can be compromised.

Take for example the following Put Credit Spread on Agrium (TSX:AGU) with shares at $96.70

SELL April, 92 strike put = $1.60 ($160.00)
BUY April, 90 strike put = $1.35 ($135.00)

Net Credit = $0.25 ($25.00)

Maximum Risk
(92-90) -$0.25 = 1.75 ($175.00)

Break even on expiration
92-$0.25 = $91.75

To summarize, this trade has a profit potential of $25.00/contract and a risk of $175.00/contract. This represents a 14% return on risk.

Confident in the Direction?

If you were confident that Agrium (TSX:AGU) is going to trend higher over the next month and a half, you could implement an At-The-Money Bull Put Credit Spread for a more attractive risk/reward opportunity.

SELL April, 96 strike put = $3.15 ($315.00)
BUY April, 94 strike put = $2.55 ($255.00)

Net Credit = $0.60 ($60.00)

Maximum Risk
(96-94) -$0.60 =1.40 ($140.00)

Break even on expiration
96-$0.60 = $95.40

In this example, the trade has a profit potential of $60.00/contract and a risk of $140.00/contract. This represents a potential  42% return on risk.

On Expiration

In the event that the stock stays the same or goes higher, both Bull Put Credit Spreads would expire profitably as the options expire Out-Of-The-Money and the full credit is realized.  The further Out-Of-The-Money spread has a higher probability of expiring worthless, however a greater risk is undertaken for that benefit.  If the investor is confident enough to take a more decisive stance on the direction of the stock, a greater credit may be obtained with a reduced risk while still taking advantage of the passage of time.

By considering a Credit Spread the the investor is able to generate cash flow by taking advantage of the passage of time.  This strategy also reduces the amount of capital required to participate as the margin requirement is typically calculated as the spread minus the credit.  By choosing a spread closer to the current value of the underlying stock, a greater credit is received which reduces the the risk.  This subsequently reduces the margin requirement further.

It is important to note that the Credit Spread strategy is not permissible in registered accounts.

Alpha Generation

Something I have discussed at a number of the Montreal Exchange Option Education Days is the theory that markets are efficient,  which is to say the stock market is a pricing mechanism where investors come together to evaluate potential return. You buy shares when you believe them to be undervalued and sell them because you think that they are overvalued.

The concept of efficiency rests with the belief that a large collection of buyers and sellers are making decisions on the basis of known, available information will establish a fair market value. That does not mean the end value is correct, only that it is based on rational expectations across a large contingent of investors using real money to establish positions.

The options market works much the same way, except that it evaluates risk rather than return. You write options if you believe that the volatility being implied is too high and you buy options when implied volatility is understating future risk.

A third component of this discussion is an understanding of the term “alpha” which is a concept that quantifies return relative to risk. Theoretically, every point on the risk scale has an attendant rate of return… i.e. higher risk begets higher return. When the return is greater than what is expected for a given level of risk, you have generated alpha or stated another way you have delivered superior risk adjusted returns.

Alpha is a core tenet in the financial industry. Institutional money managers are constantly being evaluated on their ability to produce excess risk adjusted returns; more so in the hedge fund industry where long short strategies incorporating leverage attempt to produce high real returns at coincidently high levels of risk. When it works, the numbers are compelling; when it doesn’t, the fallout is severe.

Unfortunately, risk adjusted return is rarely discussed among individual investors because most have no grasp about the mathematics of risk. Individual investing is more art than science, where decisions are usually the result of gut feelings rather than mathematical precepts.

The trick is to utilize strategies that can be adapted to efficient markets without having to earn a degree in calculus. Hence my preference for a systematic strategy of writing calls against broad based indices. In theory, if one links an unlevered index, that efficiency prices potential return to an option that efficiently prices risk metrics you should generate alpha. A position that has been borne out by the long-term performance of various covered call writing indices.

Writing covered calls against broad based indices, like the iShares S&P TSX 60 index fund (TMX: XIU) or the S&P 500 Depositary Receipts (NYSE, SPY), has generated superior risk adjusted returns than one would get by simply holding the underlying index. Evidence of this can be found in the risk adjusted returns from inception for the Mx Covered Call Writers Index when compared to a buy and hold position on XIU.

For the uninitiated, covered call writing involves the simultaneous purchase of the underlying index ETFs and writing short to medium term at-the-money calls. For example, a covered call would involve the purchase of XIU at $19.91 per share (Friday’s closing price) with the simultaneous sale of ,say, the XIU March 20 call at 25 cents.

By selling the March 20 call you have agreed to sell the XIU shares at $20 anytime between now and the third Friday in March, which is the date the option expires. If the stock is sold at $20 per share, your net return is 1.7%. If the stock remains the same, you keep the 25 cent premium and your net return would be 1.25%; the 25 cents provides some downside protection to $19.67 per share.

So in three out of four scenarios you are ahead of the game writing the covered call. If the stock rises slightly, stays the same or falls you are better off having written the covered call than simply holding the underlying ETF. Only if XIU rises dramatically do you underperform the covered call strategy. Indeed, that is the underlying strategy that is measured by the Mx Covered call writers index.

Still, covered writing indices which measure the performance of selling at-the-money calls against broad based indices, do not substantiate efficient market theory. I say that because writing covered calls against individual stocks has produced no evidence supporting the efficiency of markets. In fact, writing covered calls against individual stocks does just the opposite.

That seeming disconnect is grounded in logic. Whereas the options market is pretty good at evaluating market risk it has never been able to efficiently quantify company specific risk factors. These so-called systemic risks typically drive individual stock prices but are theoretically diversified away within a broadly based index.

So much for long term history! More recently, broadly based equity indices representing the market have themselves been difficult to evaluate. Financial markets have succumbed to crowd psychology as investors try to evaluate macro events at a time when central bank liquidity injections have blurred fundamental economic tenets.

As one might expect, we are witnessing this play out in the performance of covered call indices. Over the past ten years, for example, the Mx Covered call writers index has returned 4.31% compounded annually versus a compound annual return of 5.52% for the XIU buy and hold strategy. Still, when you divide excess return less the risk free rate by the standard deviation of the respective strategies, the risk adjusted results are very similar.

More striking is the pockets of disparity among the two strategies. Since the MCWX index holds XIU as the underlying equity, you would expect it to correlate closely with the returns from a buy and hold strategy where one holds XIU and does not write covered calls.

But in the last three years we have witnessed some unusually large gaps between the two strategies. In 2011, for example, the MCWX Index lost 0.42% compared to a loss of -11.51% in the XIU buy and hold strategy (note we are not including dividends in these performance calculations). Same with 2013, where the MCWX generated about a third of the return that buy and hold produced, which in percentage terms was the worst year of underperformance since inception.

I suspect these gaps are fallout from quantitative easing that has distorted the normal metrics that drive economies and which are ultimately reflected in broad based equity indices. In short, these outside influences are difficult for the option market to quantify.

If these assumptions are correct, then 2014 may be a transitional year. As central banks gradually withdraw liquidity, financial markets will likely revert to normal pricing metrics which can be more efficiently valued by the options market. In essence creating a scenario where the index based covered call strategy once again leads the way in the generation of alpha.