The Benefits of Call Overwriting - Call overwriting_ the strategy by lonyoo


									                                                                                                                                                              Risk Magazine September 2002

                                                                         SPONSOR’S STATEMENT

           The benefits of call overwriting
Call overwriting is gaining popularity among investors. Here, JPMorgan explores the risk/reward profile and
examines the historical performance of this strategy in the US and European markets during the past decade

         all overwriting, the strategy of selling call options against shares                                     belief that it would improve their Sharpe ratios were misleading themselves.
         held long, is gaining popularity among investors. Positive                                               These critics argued that more appropriate measures of risk, such as semi-
         absolute returns in equities have been scarce of late, driving                                           variance, probability of shortfall, value-at-risk, or utility-based metrics, would
many active investors from traditional long-only portfolios toward                                                reveal that call overwriting (and put selling) was not as attractive as
options-based strategies as a means of generating absolute returns.                                               mean/variance analysis indicated.2 In this article, we explore the risk/reward
Call overwriting is most commonly employed to enhance alpha through                                               profile of call overwriting, and examine the historical performance of the
strategic overlays and as an alternative to selling shares directly. In flat                                      strategy in the US and European markets during the past decade.
or down markets, call-overwriting can outperform owning the underly-
ing shares outright due to the premium earned from selling the calls. On                                          Call overwriting: a risk-reducing strategy
the other hand, in a rally, call overwriting can underperform owning the                                          Active investors, by definition, have views that differ from the market’s.
stock alone since it caps the upside return (see figure 1). Call overwrit-                                        In the bull market of the 1990s, many active investors focused on stock
ing’s put/call-parity cousin, cash-covered put selling, is also gaining                                           selection, where significant premiums were earned for superior skill. In
popularity as an alternative to buying shares outright.1 In Europe, call                                          the current market environment, traditional stock picking has been diffi-
overwriting is often securitised in the form of discount certificates.                                            cult at best. Employing options strategies such as call overwriting and
                                                                                                                  put selling to augment traditional stock selection allows active investors
Risk or return?                                                                                                   to more precisely express and monetise their views. Options allow an
Investors describe call overwriting’s virtues in different ways. Some view                                        investor to shape the distribution of returns by selectively buying or sell-
it as a risk-reducing strategy. Some label it return-enhancing. Others                                            ing pieces of the distribution in an efficient manner. For example, if an
argue it is neither. While call overwriting has been a staple investment                                          investor believes a stock will have little price volatility while the options
strategy for many years, it lost some of its allure during the 1990s bull                                         market indicates otherwise, selling a call against the stock lets the
market. Equity markets were delivering annual returns of 20% or more                                              investor monetise the difference in views (see figure 2). If the investor’s
with surprising ease, causing many call overwriters to underperform                                               view is correct, the strategy will add alpha and reduce return volatility.
their long-only benchmarks and their long-only peers.                                                             1
                                                                                                                   Due to put/call parity, the economics of writing cash-covered puts and overwriting
    At the same time, many market practitioners started to question the                                           calls are nearly identical. Some minor differences arise from considerations such as
wisdom of applying simple mean/variance risk measures such as the                                                 early exercise of American-style options, tax treatment and regulatory restrictions.
                                                                                                                   One advisor went so far as to remark that call overwriters had “sold their soul to the
Sharpe ratio to portfolios with asymmetric, option-like payouts. Indeed,                                          devil.” (Exploring the New Efficient Frontier, by Susan Arterian, Derivatives Strategy,
they often noted that investors who were writing covered calls on the                                             Dec/Jan 1995/96,].

  Figure 1. Call overwrite payout (ATM strike)                                                                     Figure 2. Taking advantage of distributions
                                                                                                                                                                                                      Source: JPMorgan analysis.
                                                                                     Source: JPMorgan analysis.


                    20             w/ ATM call overwrite
                                   (premium = 10)
 terminal payout

                    10                                                                                                                                             investor's view


                   –10                              stock alone                                                                                                                  monetise this
                                                    (spot = 100)                                                                                                                  difference
                                                                                                                              market's view
                         80   85    90     95     100      105     110   115   120
                                           terminal share price
                                                                                                                                                       share price
    What does the investor’s terminal return distribution look like after                                     in bull and bear markets. In a strong bull market, we would expect covered
overwriting a call? First, since the investor captures the option’s time                                      calls to underperform because upside returns are capped. Indeed, in our
premium, the return distribution shifts to the right (see figure 3). This                                     study, ATM covered calls underperformed the index in each of the top
reduces the likelihood of experiencing a negative return. Second, since                                       three years for index returns, for each of the three markets. In these years,
the investor’s return is capped, there is a probability ‘mass’ at the level                                   the market returns far exceeded the premium received for the ATM calls.
of the return earned if the stock is called away. The likelihood that the                                          However, it was a different story for OTM covered calls. Here, the
investor earns the return-if-called (the maximum return possible) is sim-                                     market needed to rally more before upside returns were capped, and
ply the probability of the stock trading above the call-strike at expiration.                                 depending on the exact strike and premium, OTM covered calls could
    From a risk perspective, the return variance after writing the call is                                    still outperform. For example, the best three years for FTSE Index returns
lower than the variance from holding the stock outright. In addition, both                                    were 1993,1995 and 1997, which had an average market return of 27%.
the probability of a negative return and the downside variability of                                          However, the OTM covered call strategy actually outperformed in each of
returns are diminished. Therefore, call overwriting can reasonably be                                                                   Call Overwrite Performance: SPX
considered a risk-reducing strategy.                                                                            Figure 4. S&P 500 call overwrite performance
    What about returns? In theory, the expected return is diminished as                                                                                                                       Call Overwrite Performa
                                                                                                           Call Overwrite Performance: SPX
well. However, since the performance of call overwriting depends on the                                                         SPX tot ret
performance of the underlying stock, the level of implied volatilities and                                                      ATM call o/w tot ret
                                                                                                                   500          105% call o/w tot ret
the strikes chosen, among other factors, it is instructive to examine how
call overwriting has performed historically in various global equity markets.                                      400

A tale of three cities                                                                                             300
For illustration, we have chosen to compare the hypothetical perfor-
mance of two sample strategies in the US, Europe and the UK, during
the past decade. While the call-overwriting strategies we have chosen                                              100
are simplistic, we believe they are useful for analysing call overwriting
under historical market conditions. We compare:                                                                      -
                                                                                                                         1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
1. Owning the S&P 500, DAX 30 or FTSE 100 alone.
                                                                                                                    Source: S&P, FTSE, Deutsche-Börse, Bloomberg, Datastream and JPMorgan analysis.
2. A ‘naïve’ call-overwriting strategy in which we overwrite the index
   each month using one-month calls, and hold the options to expiry.                                         995 1996 1997 1998 1999 2000 2001 2002                         1992 1993 1994 1995 1
   Here, we consider writing at-the-money (ATM) and slightly out-of-the-                                        Figure 5. FTSE 100 call overwrite performance
   money (OTM) 105% calls. (We include transaction costs equal to 3%
   of option premium. We do not account for any tax implications. For                                             600
                                                                                                                                  UKX tot ret
   taxable investors, call overwriting can create taxable events. We rec-                                                         ATM call o/w tot ret
                                                                                                                  500             105% call o/w tot ret
   ommend investors consult with their own tax advisors.)
    Our study indicates that a call overwriting programme can reduce the
volatility of returns, enhance performance and improve a portfolio’s                                              300
risk/return profile – even in bull markets. This was the case for both the
S&P 500 and FTSE 100 Indexes, but not entirely the case for the DAX 30
Index (see figures 4–6 and table 1). On average, writers of ATM calls                                             100
received around 30% of the index value each year in premium. For 105%
OTM calls, the level was between 6% and 12%, depending on the market.                                                -
                                                                                                                         1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
    To understand the drivers of the performance of our ATM and OTM strate-
                                                                                                                    Source: S&P, FTSE, Deutsche-Börse, Bloomberg, Datastream and JPMorgan analysis.
gies across the three markets, it is helpful to consider, separately, the returns
                                     Call Overwrite Performance: SPX                                                                     Call Overwrite Performance: DAX
  Figure 3. Call overwriting shifts return                                                                      Figure 6. DAX 30 call overwrite performance
  distribution to the right
                                                                                                                   600             DAX tot ret
                                                                              Source: JPMorgan analysis.

                                             ATM call overwrite
                                                                                                                                   ATM call o/w tot ret
                                                                                                                   500             105% call o/w tot ret
                                                  OTM call                                                         400


                                                      stock alone                                                  200


   –80     –60      -40     –20       0      20      40       60      80                                                 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
                                  Return (%)
                                                                                                                    Source: S&P, FTSE, Deutsche-Börse, Bloomberg, Datastream and JPMorgan analysis.
                                                                 SPONSOR’S STATEMENT

 Table 1. S&P 500, FTSE 100 and DAX 30 call overwrites – details of performance

                                               S&P 500                                       FTSE 100                                              DAX 30
                                               ATM call      105% Call                       ATM call        105% call                            ATM call          105% call
                    Year           Index       overwrite     overwrite       FTSE 100        overwrite       overwrite           DAX 30           overwrite         overwrite
                    1992           7.5%         16.5%           9.6%          19.8%           10.9%            13.8%              –3.8%             1.1%              –1.8%
                    1993           9.9%         14.1%          10.8%          25.2%           22.2%            27.3%              47.9%            22.6%              40.1%
                    1994           1.5%          2.7%           3.2%          –6.5%            0.7%            –2.7%              –9.0%            –1.3%              –4.7%
                    1995          38.7%         21.0%          40.0%          26.0%           25.1%            28.9%              11.5%             8.8%              29.0%
                    1996          21.4%         18.2%          21.3%          16.9%           18.9%            18.2%              22.2%            15.3%              19.3%
                    1997          34.7%         25.3%          37.7%          28.7%           22.5%            32.4%              54.7%            20.0%              43.4%
                    1998          27.9%         16.6%          26.9%          17.5%           26.0%            23.6%              21.2%             7.4%              19.3%
                    1999          20.0%         18.4%          26.3%          20.6%           26.5%            33.0%              27.6%             9.7%              16.8%
                    2000         –10.8%          3.3%          –8.7%          –8.2%            8.5%            –1.3%              –6.8%             3.6%              –2.2%
                    2001          –8.8%         –4.1%          –7.7%         –14.1%            1.0%            –8.0%             –17.8%           –16.9%             –17.6%
               2002 ytd          –27.8%         –9.0%         –21.8%         –29.6%           –9.2%           –23.7%             –42.0%           –28.4%             –37.4%
        Avg. total return         10.8%         11.3%          12.5%           9.6%           14.3%            13.5%              10.6%             5.2%               9.4%
        Return std. dev.          14.1%          7.8%          12.7%          15.3%            9.6%            13.9%              21.9%            13.5%              18.9%
     Downside std. dev.           16.0%         11.7%          15.2%          16.9%           15.5%            16.9%              24.5%            21.1%              23.4%
        Upside std. dev.          12.5%          4.8%          10.5%          13.9%            5.6%            11.3%              19.5%             8.0%              14.9%
    No. months outperf.                         72/127        115/127                         81/127          118/127                              71/127            101/127
      Avg. premium, pa                          28.7%           6.2%                          30.1%             8.3%                               31.5%              12.1%

 Assumes transaction cost equal to 3% of the option premium. Average returns are monthly returns annualised. Return standard deviation is the standard deviation of excess
 returns. Downside and upside return standard deviations are standard deviations of returns below and above the mean, respectively.
                                                                                                    Source: S&P, FTSE, Deutsche-Börse, Bloomberg, Datastream and JPMorgan analysis.

these three years, giving an average return of 30%. The S&P 500 shows                      Conclusion: enhancing risk-adjusted returns
a similar bull market picture to FTSE, with OTM covered calls outperform-                  Call overwriting strategies can reduce the variability of returns by capping
ing in two out of the top three years for index returns. OTM options per-                  upside profits and reducing downside losses, and indeed this was the case
formed better than ATM options in steady rallies because, while they took                  for all three markets in our study (table 1). In a flat or bear market, call over-
in less premium, they were less likely to expire in-the-money.                             writing improves a portfolio’s risk/return profile. Since the market downturn
    On the other hand, call overwriting the DAX fared poorly in bull mar-                  began in 2000, all of the strategies in our study had superior returns and lower
kets. For example, the top three years for DAX returns were 1993, 1997                     return variability. Even in a bull market, call overwriting can improve the over-
and 1999, with index returns averaging 43%. In each of these years,                        all risk/return profile of a portfolio, provided the call overwriter is adequately
OTM covered calls underperformed the index, and returned 33% on                            compensated for the magnitude and frequency of market rallies. In our study,
average. The DAX performed so strongly in these three years that the                       the S&P 500 and FTSE call overwriting strategies illustrate this point. The ATM
monthly 105% covered call strategy kept getting returns capped out at                      DAX call overwriting strategy is a striking display of what can happen when
5% plus the option premium. And the DAX option premiums were not                           the call writer is not adequately compensated for upside volatility.
enough to compensate for the upside moves in the market.                                        These results suggest that call overwriting and put selling strategies
    In a bear market, call overwriting typically outperforms the index as                  are particularly attractive in the current market environment characterised
the calls expire worthless and the premium received enhances index                         by weak equity performance and high option implied volatilities. While
returns. Because ATM calls have higher premium, writing ATM calls will                     past results do not guarantee future performance, our study demon-
enhance returns more than will writing OTM calls. This is indeed what                      strates that, over a wide range of market conditions, call overwriting
we have observed in our study during the recent market downturn.                           enhances returns, reduces risk and improves a portfolio’s risk/return pro-
    Why did the S&P 500 and FTSE call overwrites perform so well, even                     file. We believe that active investors can prudently employ call overwriting
in bull markets? Whether a covered call-strategy outperforms through                       (and put selling) strategies in conjunction with their core investment strate-
time depends on whether the option seller is being adequately com-                         gies to augment their returns and better tailor their risks. ■
pensated for the frequency and magnitude of market rallies, in which
call overwriting runs the risk of underperforming.
    In our study, the strength of DAX market rallies was much stronger
than for the S&P 500 and the FTSE. This is reflected in the volatility of
DAX returns, which at 22% was much higher than the 15% volatility of
S&P and FTSE returns. However, the average price of DAX options was                          Jerry Hanweck, global head of equity derivatives strategy
not significantly higher than the price of FTSE or S&P options. This                         Tel: +1 212 622 2861 e-mail:
meant that sellers of DAX options were not receiving sufficient extra pre-
mium to compensate for the increased risk of underperformance. Put                           Peter Allen, European head of equity derivatives strategy
another way, the implied volatility of the DAX options was too low rela-                     Tel: +44 (0)20 7325 4114 e-mail:
tive to the volatility the index delivered.

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