CBOE’s BXM index forms basis for structured products

The Chicago Board Options Exchange’s covered call writing index is gaining the attention of structured product makers. By John Ferry

Wall Street dealers are starting to sell structured products linked to the Chicago Board Options Exchange’s (CBOE)

S&P 500 Buy-Write (BXM) index, which was launched two years ago and is designed to track the performance of a hypothetical buy-write strategy on the S&P 500 equity index, says the CBOE.

“Right now there is no mutual fund or exchange-traded fund linked to the BXM, but it is my understanding that some Wall Street firms are in the process of developing products linked to the index, which they are presenting to high-net-worth investors,” says Matt Moran, Chicago-based vice-president of business development at the CBOE.

Buy-write strategy

The CBOE has also licensed the BXM to Boston-based Rampart Investment Management, which is marketing the strategy mainly to institutional investors. Moran says the buy-write strategy should be taken seriously by investors. It involves buying a stock or a basket of stocks while simultaneously writing covered call options on the same underlying.

The strategy lets investors take in option premiums that can help cushion downside moves in an equity portfolio. It also generally lowers the volatility of a portfolio. However, investors run the risk of their stocks being called away from them, so they have to be prepared to sell if the options they write move in-the-money. And, as writing a call option puts a cap on your upside, the strategy often underperforms when stock markets are rising. It means the strategy, if implemented soundly, would have significantly outperformed stocks in 2000 when stock prices fell, but would have underperformed in the years 1995 to 1998, when the S&P 500 rose by more than 20% a year.

Tried and tested

“The buy-write strategy has been used by portfolio advisers and wealth managers for over a decade, and the CBOE has packaged the concept into a structured product format that reduces transaction costs and provides an automated, buy-and-hold method of adding the strategy to your portfolio,” says the Structured Products Association’s New York-based chairman Keith Styrcula. “Selling covered calls is a tried-and-true strategy among high-net-worth individuals who seek to generate income by using a conservative buy-write strategy on individual stocks. The CBOE buy-write index provides an index version of this strategy in a cost-effective structure with valuations tracked daily in the financial pages,” he adds.

The methodology of the BXM index is based on buying an S&P 500 index portfolio and writing the near-term S&P 500 covered call option, generally on the third Friday of each month. The call is held until it is cash settled on the third Friday of the following month, when a new one-month call option is written. The CBOE commissioned information company Ibbotson Associates to test how successful the strategy would have been if it were applied retrospectively. The study found that the compound annual return of the BXM index over the almost

16-year history of the study was 12.39%, compared to 12.2% for the S&P 500. However, the BXM only had around two thirds of the volatility of the S&P 500. Using a risk-adjusted returns measure called the Stutzer index, which is a generalization of the Sharpe ratio that controls for skew and kurtosis in asset returns, the researchers found that the risk-adjusted return for the BXM was 0.22 versus 0.16 for the S&P 500.

“For a modest portion of an individual’s portfolio, the buy-write strategy can be a compelling strategy. It provides less volatility than the index itself and it could also outperform the cash index in a declining market, or a market that is trending sideways,” Styrcula says.

CBOE’s Moran says the buy-write strategy has historically outperformed a standard cash equity investment in the same underlyings because traditionally implied volatility on equity index options has been higher than realised volatility. This means that, historically, options have been overpriced. The idiosyncrasy was first outlined in a study that Morgan Stanley produced way back in 1990. Ibbotson’s research came up with a similar pattern. The researchers found that over the 190-month historical period that they covered, the S&P 500 options were found to have an average implied volatility of 16.5% and an actual, realised volatility of just 14.9%. They also found that the average monthly premium on the call options was 1.69% of the underlying stock value.

That kind of research makes a strong case for buying a structured product linked to the BXM. Moran concedes, however, that what took place in the past is not necessarily a guide to what will happen in the future. “In the past, there appears to be some evidence to suggest that if you had been a consistent seller of index options you would have outperformed, but I can’t say the phenomenon will continue in the future,” he says.