Ripe for overwriting

Special Report - Options

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The collapse of Lehman Brothers, along with the acquisition of Merrill Lynch by Bank of America and the US Federal Reserve's rescue of US insurer American International Group, sent another wave of volatility crashing through the equity markets in September.

The Chicago Board Options Exchange's (CBOE) Vix index, which measures the market's expectation of 30-day volatility on S&P 500 index option prices, leapt from 24.66% on September 12 to 36.22% on September 17. With risk-averse traders ditching shares across the board, the S&P 500 index slumped 7.6% between September 12 and 17, while the Dow Jones Eurostoxx 50 index fell by 7.9% over the same period.

The market suffered another shock on September 29 following the rejection by the US Congress of a $700 billion rescue fund proposed by the US Treasury. The S&P 500 plunged 8.78% to reach 1,106.42, while the Vix index jumped to 46.72%.

But while many equity and structured product investors withdraw to the sidelines, high volatility over the course of this year has boosted interest in call-overwriting strategies, which involve selling call options on a stock or a portfolio of stocks. With volatility likely to remain high in the coming months - boosting the value of the call options the investor writes - the strategy is likely to continue to be popular.

"There is a lot of interest in this at the moment, partly because of the higher volatility in equity markets, but also because of the perception the future doesn't hold great equity returns," says Ron Egalka, Boston-based chief executive of Rampart Investment Management, a US asset management firm specialising in the implementation of call-overwriting strategies.

Few investors think stock markets will see a strong recovery in the short term - although the new rules imposed in September by both the UK Financial Services Authority and the US Securities and Exchange Commission to temporarily ban short selling on financial stocks may prevent a further nose-dive in these firms' share prices. Nonetheless, conditions have been ripe for call overwriting.

"Among other things, people generally tend to correlate their interest in call overwriting with the level of implied volatility," says Moritz Seibert, London-based director of equity derivatives structuring at Royal Bank of Scotland (RBS). "This is a strategy that can provide added value to an equity portfolio at the moment. Clearly, if you perceive markets are going to turn very bullish, then you should not be running this strategy. But I think it is a very good strategy for the current market environment. Nobody really knows where the market is going, but we do know implied volatility is relatively high."

Simple strategies

Traditional call-overwriting strategies are very simple. For example, an investor might systematically sell 103% strike calls on the Dow Jones Eurostoxx 50 or the S&P 500 indexes on a monthly basis. Dealers report strong interest in call-overwriting strategies on leading stock indexes, but they also say investors have been looking for more specific, tactical plays this year.

"Index options have historically been a bit more expensive (than single-stock options), so this is an attractive strategy at the index level," says Stephen Einchomb, head of equity derivatives research at JP Morgan in London. "But we've also seen quite a bit of interest in single-stock call overwriting."

Equity derivatives research desks have been busy looking for specific stocks that could provide the juiciest call-overwriting returns. Naturally, bank stocks have offered some of the best prospects this year. On September 9, a week before Lehman Brothers filed for Chapter 11 bankruptcy protection, RBS sent out a strategy note to its clients suggesting they implement a call-overwriting trade on Barclays. At the time, the UK bank was trading at 370 pence. RBS analysts had downgraded the bank from a hold to a sell, and the company had the fifth highest implied volatility level in the FTSE Eurotop 100, an index that tracks the 100 most highly capitalised blue-chip companies in Europe. The recommendation was to sell December 2008 calls on Barclays at the 409p strike level, which at the time had an indicative price of 22p per call. The investor would therefore earn a sizeable premium, while the share price would have to rally by 10.54% before the call would be exercised and the investor would be obliged to sell Barclays shares at the strike price. By September 16, the share price had fallen to 308p.

As well as presenting investors with single-stock and index trading ideas, banks are also looking for ways to enhance basic call-overwriting strategies. BNP Paribas, for example, is touting a buy-write strategy - another name for call overwriting, also referred to as covered-call strategies - with a further 'enhanced dynamic mechanism', designed to minimise the probability that the call options the investor sells will be exercised. The strategy is available via its Harewood Covered European Equity fund, which writes call options on the Dow Jones Eurostoxx 50 index.

Most call-overwriting strategies involve systematically selling options on a monthly basis, but the BNP Paribas strategy involves selling call options daily, says Olivier Osty, deputy head of global equity and commodity derivatives at BNP Paribas in London. "Selling calls on a daily basis means you are not subject to any strong moves on one or the other side of the market," he adds.

The strategy uses a so-called dynamic re-strike mechanism, which balances the opportunity for earning high premium with potential upside market performance by searching for the best option strikes to suit current conditions. It does this by applying a trend indicator approach to the call overwriting strategy. "We take into account the momentum of the market," says Osty. "Depending on which way the market is trending, the strategy might decide to sell out-of-the-money calls if the market is moving on the upside, or it might decide to sell slightly in-the-money calls if the market is bearish. That means we capture value in two ways: through the momentum of the market and also the implied volatility of the market."

If the trend indicators suggest a bearish market, the fund might sell high premium options, with the strike set at 98% of the index price. But if trend indicators suggest a bullish market, then the fund could sell low premium options with a strike set at 102% of the index price. The fund sticks to using the Dow Jones Eurostoxx 50 because the underlying options market on that index is highly liquid.

RBS is adding a different twist to the strategy. It is seeking to combine the potential of the 'turn-of-the-month' effect with call overwriting. The turn-of-the-month effect refers to a historical phenomenon where equity returns immediately before and after the end of the month are above average. The bank therefore suggests a simple strategy of being long the equity market on those days, with cash earning interest in a deposit account the rest of the time. RBS has already adopted this approach in a number of its structured note offerings, but is now combining it with a call overwriting strategy through its Synergy Fund.

"At first, we rolled out turn-of-the-month as a stand-alone idea to show investors what we had discovered," says Seibert. "We've now taken it a step further and decided if there is excess volatility during the month that doesn't yield anything, then perhaps we should sell that volatility off by selling calls during that period. Then we can close the position again once the end of the month arrives, when you can capture strong long-only returns."

The Synergy Fund takes long exposure to the FTSE 100 index at the start of the fourth to last trading day of each month and sells at the end of the fourth trading day of the following month. As analysis suggests the market should perform, on average, less strongly between this turn-of-the-month period, yet with similar volatility levels, it should be profitable to write call options during this time. The Synergy Fund therefore writes 100/105 call spreads each month, with the tenor spanning the weeks between the turn of the month.

Back-testing suggests Synergy would have returned more than 16% a year after fees and transaction costs between January 1998 and February this year. The total return of the FTSE 100 over the same period was 4% a year, says RBS. Meanwhile, Synergy's annualised volatility was around 12%, less than the 19% registered by the FTSE 100. Year to date - until November 5 - the strategy has returned 12%, compared with a 29.4% drop in the FTSE 100.

In general, the performance of systematic call-writing strategies this year has been reasonable in relation to long-only equity strategies. The CBOE's S&P 500 BuyWrite index, which tracks the performance of a hypothetical call-writing strategy on the S&P 500, is down slightly compared with its level at the start of 2007, but this is over a period in which the underlying index has leapt around wildly (see graph). In the long term, however, proponents of the strategy should do well on a risk-adjusted return basis (see box).

There is, of course, a potential downside to covered-call writing - a sharp rise in stock prices. "Call overwriting works best when you have gradually rising markets," says Colin Bennett, a director in equity derivatives research at Barclays Capital in London. "In the run-up to the tech bubble in the late 1990s, for example, when we had increasing volatility but also rapidly rising markets, that was a bad time to be overwriting stocks."

In addition, higher volatility may mean juicier premiums, but it also means a higher probability of the stock price breaching the strike price on the calls. "Theoreticians would argue that the level of premiums is fully commensurate with the level of risk you're undertaking," counters Rampart's Egalka.

Such negatives mean some investors will not consider getting into call overwriting at the moment, even given the potential for high returns. But for long-term investors who are happy to ride out equity market ups and downs, the strategy can give them some extra bang for their buck. That is why dealers are keen to innovate to see how call overwriting can be combined with other strategies to create new investment possibilities.

Banks may well also start to look at how the strategy can be taken into other asset classes. Seibert of RBS says applying sophisticated call writing strategies in other areas could be the next stage of development, with commodities the most obvious asset class to move into. "There is a different type of skew with commodities," he says. "It's more of a smile, which means there are also strong expected upside returns as opposed to just strong downside returns. Therefore, the implied volatility, which you lock in by selling upside calls, is actually higher in contrast to equities, which means the premium income will be higher."

In some respects then, call overwriting remains an underdeveloped strategy. Applying call overwriting as an additional premium-generating strategy outside the equity arena is just one avenue developers can take.

LONG-TERM PROSPECTS

Several studies suggest call overwriting can produce superior risk-adjusted returns for investors over the long term.

Last year, the Fund Evaluation Group (FEG), an independent US investment firm, analysed the risks and returns of the Chicago Board Options Exchange's (CBOE) Dow Jones Industrial Average (DJIA)-based buy-write index (the BXD) from October 1997 to November 30, 2006. The BXD tracks a hypothetical portfolio containing a long position indexed to the DJIA on which are sold a succession of one-month at-the-money call options. The FEG found the BXD posted returns similar to several equity indexes, but with significantly less volatility.

The BXD returned 7.4% on an annualised basis, compared with 7.72% for the DJIA and 8.1% for the Russell 2000 index, which measures the performance of US small-cap stocks. But the annual standard deviation on the BXD was around 75% of that experienced by the DJIA and just over half that of the Russell 2000 index. The annualised Sharpe ratio of the BXD was 0.39, versus 0.34 for the DJIA and 0.32 for the Russell 2000.

Ibbotson Associates, a Chicago-based research company, also conducted a study of long-term returns on call overwriting that suggested risk-adjusted returns are superior to those on long-only strategies. The company looked at a hypothetical $1 investment in the BXM, the CBOE's S&P 500-based buy-write index, from June 1988 until March 2004. The company found the compound annual return of the BXM over the 16-year period was 12.4%, compared with 12.2% for the S&P 500. However, the BXM had about two-thirds of the volatility of the S&P 500.

The risk-adjusted performance of the BXM as measured by the Stutzer index - an alternative to the Sharpe ratio, which tries to alleviate the normal distribution assumption of this measure - was found to be 0.22 versus 0.16 for the S&P 500. Over the 190-month period of the study, S&P 500 options were found to have an average implied volatility of 16.5% and a realised volatility of 14.9%. The average monthly premium received from selling options was 1.69% of the underlying index value.

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