The options industry continues to set new trading records every year. Unfortunately, despite this explosion in volume, investors remain skeptical of the options markets. For these skeptics, the notion of using options in conjunction with their equity portfolios remains a daunting prospect. The options industry has spent millions of dollars developing proprietary productsto lure reticent equity traders into the fold.
But few of these products have managed to withstand the test of time. Some of them simply vanished into obscurity. Others failed to garner enough volume to merit serious attention. Once in a great while, however, a product comes along that is inventive enough to survive the perilous options world.
Hurdles
One such product is the CBOE's BuyWrite Index (BXM). The BuyWrite product line has slowly managed to carve out a niche in the options world.
The BuyWrite Index faced a number of hurdles when it was launched, not the least of which was its name. Although BuyWrite is a common term among options traders, few outside the industry have ever heard of it. Instead, they refer to the strategy of buying an underlying security and writing a call against it as a "covered call."
When the BuyWrite Index was created in 2001, covered calls had a bad reputation in the equity world. Many equity traders still had nightmarish memories from the late 1990's. That's when their covered call strategies badly underperformed the rampaging bull market. As a result, the CBOE had to cloak its covered call index with the archaic name BuyWrite Index just to give it a fighting chance with its target market.
Although the name BuyWrite Index remains a mystery to many investors, the underlying mechanics of the product are quite simple. The BXM replicates the return of owning the underlying S&P 500 index and writing calls against it.
"The strategy is essentially selling the front month at-the-money calls," says CBOE Vice-Chairman Ed Tilly. "For the purposes of the BXM, it would be owning the S&P 500 index and selling the front month at-the-money calls in the SPX."
While many hedge funds and portfolio managers write calls against their stocks, they usually only do so about once a quarter or once a year. However, the BXM writes calls against the S&P 500 every month. This increased frequency was chosen for two reasons. The first reason is to capture the higher level of time decay that comes from writing short-term options as opposed to longer-term options.
"Most people who write calls against their portfolios choose to write longer dated, out-of-the-money-options. But we decided to go with one month at-the-money, or slightly out of the money, calls," says Matt Moran, Vice-President of Business Development for the CBOE. "The reason is that, if you write twelve 1-month options, then you should collect nearly twice as much time decay as if you wrote four three-month options."
The second reason for writing calls every month has to do with the endless battle for volume in the options markets. With six exchanges battling for the title of "world's largest options exchange," every single contract is vital. The SPX's proprietary license and steady volume have made it one of the CBOE's most powerful weapons. Since the BXM requires licensees to roll SPX positions every month, it is helping to generate additional volume and increased revenue in the CBOE's signature product.
Decay vs. Capital Appreciation
Choosing which call to write is the most important part of any covered call strategy. Because there are so many choices, covered call strategies usually fluctuate widely from one trader to the next. Some traders opt to write long-term calls in order to eliminate the hassle of rolling their positions every month. Others choose to write significantly out-of-the-money calls in order to maximize the upside potential of their portfolio. Still others choose to write at-the-money calls, drastically limiting their upside potential but maximizing their time decay.
The CBOE opted for the latter approach, and it raised more than a few eyebrows in the options industry. By choosing time decay and downside protection over capital appreciation, many thought that the CBOE had hamstrung its new product. These doubts were put to rest when Ibbotson & Associates released a study that found the BXM actually outperformed the S&P 500 in the period from 1988-2004. This same study found that the BXM achieved its returns with only two-thirds of the volatility of the S&P 500. "This strategy is meant to reduce risk," says Moran. "The Ibbotson study, along with the long-term track record of the BXM, back that up. The BuyWrite strategy, over the long term, should actually lower your overall portfolio volatility."
The Upside
Perhaps the BXM's most intriguing benefit for buyside traders is its inherent simplicity. Traders who write covered calls against their own portfolios have to deal with a number of headaches. First, they have to endure the hassle of managing their underlying positions. Then, they have to go through the lengthy process of selecting the month, strike and price of the calls that they wish to write. Finally, when their calls are set to expire, they have to relinquish their underlying or go through the aggravation of rolling their calls to another month. It's a difficult and time-consuming process that many traders simply choose to avoid.
However, there is another option. Traders can choose to sit back let the BXM do all of that work for them. Since the BXM replicates the returns from owning the S&P 500 index and writing at-the-money calls against it, it takes all of the hassle out of covered call strategies.
"The simplicity of this product is its key selling point," says Moran. "If you like the idea of writing covered calls, but you don't want to mess around with the underlying or anything else, this packaged product can be very appealing. You don't have to worry about rolling your calls or even dealing with the hassle of expiration."
Although the CBOE created the BuyWrite Index, it isn't executing the strategy itself. Instead, the CBOE licensed the BuyWrite strategy to a number of brokerage firms. In turn, these firms have created their own products that replicate the strategy of the BXM. So far, the most popular BuyWrite products are closed-end funds and structured notes. As of press time, thirty closed-end funds and structured notes are indexed to the BuyWrite products with a combined asset value of over $20 billion. Most of these products are identical, although a few incorporate interesting tweaks such as tax minimization strategies.
Appealing Indexes
The high time decay and relatively low volatility of covered call indexes have made them particularly appealing in today's ever-fluctuating market. Attempting to capitalize on this popularity, the CBOE recently launched two companion products to the BXM. The BXD replicates writing covered calls on the Dow Jones Industrial Average and BXN replicates writing covered calls on the Nasdaq 100 Index. Although these products are relatively new, they have already begun to attract the attention of a new class of customer-yield hungry traders. "Many funds and retail brokers are now offering our buy-write products as an alternative for yield-conscious investors," says Moran. "The yield of the BXM, in terms of options premium, has averaged about 1.6 percent per month. That is nearly 20 percent per year, which is a very attractive yield for investors. On the BXN, you have even higher yields due to the higher volatility in the Nasdaq market. The yields in that product have averaged about three percent per month."
Comments or questions about the column can be sent to Mark.Longo@sourcemedia.com
