Can You Beat the Market? Searching for Answers. Part II

See Part I.

I know that being able to find individual stocks that out-perform the market averages is a skill I lack.  I have not made the attempt in years.  If you have that skill, more power to you.

The question is:  can using risk-reducing option strategies enhance returns?  I'm looking for an investment strategy that increases my earnings at the same time that is reduces risk.  Isn't that what every investor wants to find?  Apparently not. 

Despite the evidence that using options gives investors (and traders) a better chance to beat the market – and with less risk – many shy away from options.  In fact, my quest (part I) to pique the interest of personal financial bloggers has not borne fruit. 

I'm not interested in only teaching investors who have an interest in options how to take advantage of this excellent risk-reducing tool, but what I'd love to accomplish is finding a way to get the average investor – who has never heard anything positive about stock options – to adopt option strategies as a method of guaranteeing that his/her retirement portfolio can survive any market crisis.  The strategy discussed today is not that effective and can offer no such guarantees.  Later in this series, such a strategy will be covered. 

The idea of buying options doesn't work for me, and I discourage that strategy whenever possible.  But for anyone who buys stock, or takes a passive investing approach and owns shares of broad-based ETFs (exchange traded funds), there is more than one option strategy that should be considered.


Covered Call Writing

Today the discussion is on covered call writing, which involves owning 100 shares of stock and selling someone else the right to buy your stock at a specified price for a limited period of time.  When you do that, you are selling (writing) a call option, for which you are paid a cash premium that is yours to keep – regardless of whether the option owner eventually buys your stock.

I consider this strategy to be one of the three basic conservative option strategies because it is among the easiest methods for an option rookie to use and understand.  

The purpose of this series is to compare the relative performance of various strategies, and data must be available.  Fortunately the Chicago Board Options Exchange (CBOE) has published indexes that measure exactly the performance of the investing methods we want to compare.  These are the Buy-Write (a term synonymous with covered call writing) Indexes. 

The first of these to be published was BXM, based on the S&P 500 Index.  Today, there is also BXN, an index based on buy-writing the NASDAQ 100 (NDX), and BXR, based on writing covered calls on the Russell 2000 (RUT) index.

The methodology for each of these indexes is the same, and can be found at the CBOE site.  The methodology involves:

Own a basket of stocks equivalent to owning the index.

On expiration Friday, approximately one hour after the market opens for trading, sell one call option that is out of the money, but as near the current index price as possible.  The call sold expires in one month and is held through expiration, when the process is repeated.  There are no adjustments.

Now that we know about these indexes, how did each of them perform, compared with their individual benchmark indexes?  This is a direct comparison between a covered call writing strategy vs. buy and hold for three different portfolios.

to be continued

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2 Responses to Can You Beat the Market? Searching for Answers. Part II

  1. jeff partlow 09/18/2009 at 2:09 PM #

    Hi Mark,
    The 3 indexes you mention are passive covered call indexes that merely perform roughly in-line with overall benchmark measures such as the S&P 500. Disciplined, actively-managed covered call portfolios can outperform these benchmarks. The alpha is achieved primarily through value-oriented stock selection and active position management (e.g. rolling at appropriate times). I am in the process of demonstrating this outperformance over time on my blog:
    http://coveredcallsadvisor.blogspot.com/
    The market-beating returns to-date can be viewed on this post:
    http://tinyurl.com/lc49cy
    Regards,
    Jeff

  2. Mark Wolfinger 09/18/2009 at 3:00 PM #

    Jeff,
    Of course they are passive indexes. How else can I compare the results of ‘pure’ covered call writing – with no adjustment and no emotions getting in the way of determining the results?
    If you suggest a different comparison would provide any meaningful results, then I strongly disagree with you.
    I note you describe how your portfolio CAN outperform. Gee whiz. Really? How educational it is to learn that. Wow.
    Did you also know that such portfolios and severely under-perform, or is this a one-way street for you?
    And seem to understand alpha when you define it: Extra profits resulting from superior stock selection. But, this statement tells me you don’t really know what alpha is. There is no alpha derived from ‘rolling at appropriate times.’
    There certainly should be extra profits from good risk management, but it’s not alpha.
    In general, I find that people who make and publish stock picks are doing a great dis-service to the people who read the posts. An investment that’s appropriate for you may be entirely inappropriate for someone else.
    I understand that you are trying to boost readership for your blog, and that’s entirely appropriate. I also congratulate you on having a good trading year. But I frown on what you do.
    The vast majority of investors cannot pick stocks that outperform. I don’t like to encourage readers into believing they can easily do it.
    Mark