Writing covered calls or cash secured puts to generate income and reduce share costs are tried-and-true option strategies. Generally supporting portfolio performance in down, flat and slightly rising markets. In fact, the worst case scenario for options writing is that the underlying stock rises significantly in which case the written option caps your upside. But even with this scenario, you earn the maximum potential profit. Albeit a profit that may pale in comparison to the rapidly rising value of the underlying shares.

When determining the long-term merits of an option writing strategy, one has to have some view as to how often stocks, or stock indexes, make significant moves. If, for example, it were shown that stock prices frequently defy the mathematics of a lognormal distribution, then options writing would probably not measure up as a standard long-term strategy equivalent to “buy and hold.”

However, most studies conclude that, longer term, option writing generates a return similar to a buy-and-hold strategy, with less risk. In Canada, the Montréal Exchange’s Covered Call Writers Index (symbol MCWX) and in the U.S., the CBOE Buy Write Index (symbol BXM), have both shown that a passive option writing strategy produces the same return associated with buy and hold, with about 70% of the associated risk. And the data goes back 16 years in Canada and
24 years in the US.

Of course whenever looking at history, one must be mindful that the past is not necessarily indicative of the future. But there is an academic basis for the numbers.

The academic community spends a lot of time talking about the efficiency of the financial markets. And while there are various camps as to just how efficient markets are, there is a reasonable position that states the following; the current price of a stock reflects the markets best assessment of value based on dissemination of all publicly available information.

The stock market allows you to take a position if your view on a stock’s potential differs from the view of the general public. You buy if you think the market is understating future potential, and sell if you think the market is overstating future potential. But, and this is key to the discussion, you invest in stocks for the potential based on direction.

Unlike the stock market, the options market does not pit buyers and sellers on the basis of potential, but rather, does so on the basis of risk. The premium paid or received from an option is the market’s best guess as to the risk inherent in the underlying security. This so-called implied volatility concept is simply the option market quantifying risk.

For example, consider the straddle as a strategy. If you buy or sell a straddle – i.e. you buy or sell a call and a put – you have entered a volatility trade, which is not directionally based. If you were to pay a total of $10 for the call and put on a $100 stock, you want the stock to move up or down by at least $10 per share. You are not concerned about direction, you are concerned about the extent of the move. It is this strategy that makes the option market unique, as there is no other market I am aware of, that allows one to enter non-directional trades.

If we accept that the option market is also efficient, then the strategy of writing covered calls or cash secured puts, brings together two efficient markets; one that prices potential (the underlying stock market) and another, that prices risk. Theoretically, if the markets are really efficient, option writing should produce better risk adjusted returns than a buy and hold on the underlying index. In which case, maybe past risk adjusted performance metrics will indeed be repeated.