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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 C 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. 2 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, www.derivativesstrategy.com]. Figure 1. Call overwrite payout (ATM strike) Figure 2. Taking advantage of distributions Source: JPMorgan analysis. Source: JPMorgan analysis. likelihood 20 w/ ATM call overwrite (premium = 10) terminal payout 10 investor's view 0 –10 stock alone monetise this (spot = 100) difference –20 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 600 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- 200 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.) 400 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 200 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 400 300 stock alone 200 100 - –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 CONTACTS 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: email@example.com 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: firstname.lastname@example.org tive to the volatility the index delivered.
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