Covered Calls for the Long Run

In a low-implied-volatility environment, writing covered calls is a highly effective investment strategy. As a follow-up to Friday's piece about writing covered calls on individual issues and specific stocks, today I'll focus on some of the products available for investing in a broad market, covered-call strategy.

Covered-call writing received a huge boost last July when Chicago-based research firm Ibbotson Associates published a study on passive investment strategies. The study had a particular focus on the buy-write strategy based on the Chicago Board of Option Exchange's BuyWrite Index (BXM). The BXM is a passive or mechanical investment strategy based on selling near-term, near-the-money S&P 500 calls against the underlying index. The call is held until expiration, with a new one-month call being written on the third Friday or expiration of each month.

Sitting on a Benchmark

The study showed that over the past 15 years, the BXM has delivered a compounded annualized return of 12.39%, slightly better than the SPX's 12.20%, but with 34% less volatility or market risk. As a purely passive investment program, it has produced superior returns while simultaneously reducing the risk by one-third. As of Monday's close, the BXM is up 1.7% year to date, while the S&P 500 is up just 0.04%. One drawback of covered-call strategy is that it greatly reduces the upside potential; in those years that the SPX has gained more than 18%, the BXM has underperfomed by an average of 6.5% per year. But this has been more than offset over time, as the BXM outperforms the SPX during down or flat years.

The BXM's outperformance highlights the fact that many times a successful investment strategy rests on the discipline of not deviating from the defined program. Unfortunately, both professionals and individuals often let emotion and short-term action lead them astray. This may come in the form of adjusting strikes and expirations or using puts to offset existing positions. A general notion in options trading is that adjustments are usually made for defensive reasons, and they convolute the initial investment thesis. The important point is that the BXM, or any other long-term, buy-write program, sticks with the strategy regardless of current implied volatility.