The Investment Scientist

Wealth Preservation in Bear or Flat Markets: Call-Writing Strategy

Posted on: December 5, 2008

I wrote this article in early December 2008. Amazingly, it is one of the least read in my blog. Hadwealth-preservation someone read it and followed it, he would have earned 10% return so far in 2009.

– Michael Zhuang 3/10/2009

At the moment of writing this, SPY, the exchange traded fund (ETF) for the S&P 500 index, is trading at $85.95 and the near at-the-money call option (with strike 86 and only eight days until expiration) is trading at $3.45! (A call option is the right to buy the underlying stock at the strike price. At-the-money means the option strike price is equal to the price of the underlying stock.)

The at-the-money call premium is a full 4% of the underlying index price! Historically, that number has been in the 1% to 2% range.

What does 4% premium imply?

A 4% premium implies that, if you sell (write) a call option, you will have the following contingent future cash-flows:

  • You keep this 4% premium as long as the market stays flat or down (in the next eight days).
  • You keep part of the premium as long as the market does not rally more than 4%.
  • You lose money if the market rallies more than 4%. The higher the market goes, the bigger your loss.

If you repeat the above pattern every month, you will manage to transfer wealth from bull markets to bear and stagnant markets.

How would have this strategy worked in history?

To see how this strategy would have worked in the past, I extended the research performed by Professor Robert Whaley of Duke University and got the following numbers:

Year S&P Call-writing
1988 4.1% 4.0%
1989 27.3% -2.2%
1990 -6.6% 10.5%
1991 26.3% -1.9%
1992 4.5% 7.1%
1993 7.1% 7.0%
1994 -1.5% 6.0%
1995 34.1% -13.1%
1996 20.3% -4.8%
1997 31.0% -4.4%
1998 26.7% 7.7%
1999 19.5% 1.6%
2000 -10.1% 17.5%
2001 -13.0% 2.1%
2002 -23.4% 15.7%
2003 26.4% -7.0%
2004 9.0% -0.7%
2005 3.0% 1.2%
2006 13.6% -0.3%
2007 3.5% 3.1%
2008 -38.6% 11.1%

Data source: proprietary

Note that in the years when the S&P 500 had 20% returns or higher, the call-writing strategy typically lost money; but in the years when the S&P 500 lost money, the call-writing strategy was very profitable.

Specifically, during the dot-com bust years of 2000 to 2002, the S&P 500 fell by a total of 41.1%. If one had added a call-writing strategy to one’s portfolio, one would have limited the loss to 11.6%. In addition, one would have recovered all the loss by November 2003, as opposed to October 2007 for the S&P 500 index.

Using ETFs to achieve the same result

For people who have no experience trading options, there is a pair of ETFs to help them achieve the same result.

In 2002, The Chicago Board of Options Exchange (CBOE) commissioned Dr. Whaley to create an enhanced S&P 500 index by basically overlaying a monthly at-the-money call-writing strategy on top of the S&P 500 index. The end product was called the BXM index. This year, an exchange traded fund company, Invesco PowerShares, created an ETF to mimic the BXM index. The symbol of this ETF is PBP.

To achieve the same effect as call-writing, one only needs to purchase PBP and sell short SPY. So far in 2008, this strategy has generated an 12% return. In a year when all asset classes fell by 40% to 50%, does that not taste like dew in the desert?

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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