Strategy Performance 2008

Covered call writing is a low risk equity strategy. Which is to say, you have less risk writing covered calls against an equity position than you have with a pure equity position. In fact, the strategy has, over the long term, actually produced positive alpha (i.e. better risk-adjusted returns than one would get by simply holding the underlying equity position), relative to a pure buy and hold equity strategy.

My preference for this strategy is rooted in the positive alpha argument. I say that because we can find ample evidence of positive alpha over the long term. For example, the MX Covered Call Writers Index (symbol MCWX), which measures the performance of a passive covered call writing program on the iShares CDN S&P/TSX 60 Index Fund (TSX: XIU), supports the positive alpha argument. Since 1993, when the Montréal Exchange started to measure the MCWX, it has not only outperformed a buy and hold strategy, it has done so with less risk.

See chart at http://www.m-x.ca/indicesmx_mcwx_en.php, which compares MCWX to XIU.

Having said that, covered call writing is not always the best option strategy. In fact, it rarely produces the best return in any given year. Particularly when compared to other basic strategies, like put buying, call buying, straddle buys and uncovered call writing.

To make the point, I examined the performance of covered call writing versus the other strategies throughout 2008. Not surprisingly, covered call writing was actually the worst performing option strategy during the measuring period (see accompanying table).

The study looked at the twelve option expiration dates that occurred during 2008. In each case, we assumed that the investor entered a strategy (the first entry date actually occurred on December 24th, 2007, and finished at the last expiration date in 2008 (December 19th, 2008).

With each strategy, we assumed the investor entered the position on the Monday following an expiration, and held the position to expiration. The results are interesting. At the top of the list, not surprisingly, is put buying which returned 85.48%.

Straddle buying (buying one-month at-the-money calls and puts on XIU) was the second best strategy at 39.08%. That’s interesting given that straddle buying is a volatility play. Because of the extreme levels of volatility during the year, the cost of buying straddles was significant. What this tells us, is that despite high levels of implied volatility, the option market actually understated the actual level of volatility during the year. Even call buying, which while not successful, did much better than covered call writing.

Normally, with option premiums at such high levels, one would opt for option writing strategies. But last year, such a move would have underperformed. Although, despite the negative implications, we can take solace from the positive alpha argument. Because despite the underperformance of covered call writing when compared to other option strategies, it still did much better than simply holding XIU.