Buy-Write (Options) - Explained
What are Buy-Write Options?
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Table of ContentsWhat are Buy-Write (Options)?How Does a Buy-Write Options Strategy Work?Implementing a Buy-Write TradeAcademic Research on Buy-Write (Options)
What are Buy-Write (Options)?
Buy-write is an options-based strategy in which an investor buys a stock, and at the same time, sells a call option on that very stock or asset. In this way, he/she can earn option premium, and hence, create income. Since the underlying position already provides a cushion to the options position, the risk of selling the option gets reduced. This strategy mirrors the strategy of writing or selling a covered call on the current position in the underlying asset. However, the timing of buy-write and writing a covered call varies.
How Does a Buy-Write Options Strategy Work?
The buy-write strategy is based on the assumption that the market price of the underlying asset will not jump significantly from its existing price levels before it gets expired. This helps the investor (writing the call) in receiving premium by selling its options. It is important to keep the options strike price more than the price shelled out for the underlying asset. However, one must note that the more the strike price, the lesser amount of premium the investor will get. Another factor that results in higher premium is the timing until it expires. The more the time, the better the premium. But then the longer the wait for expiration period, lesser liquid the market will be, and the lesser will be the price. Hence, it gets too crucial to follow a balanced approach when dealing with strike price and expiration. If the price of underlying asset is more than the strike price, then the investor needs to exercise the option either at the time of or before the maturity date. This will lead to asset being sold at the strike price. He/she enjoys receiving premium indeed, however, they dont take advantage from excessive profits in the underlying price of the asset. The investor is of the belief that underlying price remains less in the short-run, and eventually gets higher in the long-run. Therefore, the investor gains by being patient for the increase in price in the long-run.
Implementing a Buy-Write Trade
Say, an investor finds XYZ stock as a reliable investment in the long-run. However, he/she is not completely confident about the time when the stock will be highly profitable. He/she plans to buy 100 shares in the stock market for $10 per share. The investor assumed that the price wont hit a rebound anytime soon, and thats why, he/she plans to exercise a call option for the same stock at a price of $12.50, therefore, offering it on sale for a premium amount of $2.5 per share. Till the time of maturity, if the price tends to be less than $12.50, the investor will retain the premium amount and the underlying stock. In case, the market price at the time of expiration period is $13 per share, he/she will not be able to secure the additional profit of $0.50 ($13 - $12.50). It will be interesting to note that this $0.50 amount is not the money that the investor didnt receive, but the money that he/she lost. When the investor plans to write a naked call, he/she will be required to approach the open market in order to buy shares to deliver. And the excessive amount of $0.50 per share will be considered as an actual capital loss.
Academic Research on Buy-Write (Options)
- Return and risk of CBOEbuy writemonthly index, Whaley, R. E. (2002). Return and risk of CBOE buy write monthly index.The Journal of Derivatives,10(2), 35-42. Ederington and Guans article calls into question the informational efficiency of option pricing in the real world, by showing that easily constructed positions earn higher returns than they should. Whaleys article adds evidence of a somewhat different kind to this conclusion. The Chicago Board Options Exchange has recently created an index to measure the returns to a basic covered call strategy that is long the S&P 500 index portfolio (SPX) and short an (approximately) at-the-money one-month SPX call option. In this article, Whaley describes the new index and then uses it to examine the returns to a basic covered call strategy from 1988 to 2001. Measuring the risk of a covered call presents some issues, because it is highly non-normal. Dealing with these, Whaley shows that under several standard measures of investment performance, the covered call strategy has been unusually successful, earning almost as much as the S&P index, with substantially lower risk.
- The risk and return characteristics of thebuy-writestrategy on the Russell 2000 Index, Kapadia, N., & Szado, E. (2007). The risk and return characteristics of the buy-write strategy on the Russell 2000 Index.Journal of Alternative Investments, Spring. Using data from January 18, 1996 to November 16, 2006, we construct and evaluate returns on a buy-write strategy on the Russell 2000 index. The results demonstrate that the strategy has consistently outperformed the Russell 2000 index on a risk adjusted basis, when implemented with one month to expiration calls and when performance is evaluated using standard performance measures. The out-performance is robust to measures which specifically consider the non-normal distribution of the strategy's returns. However, the consistent performance advantage does not remain if we utilize two month to expiration calls. To evaluate the performance in varying market conditions, we break our sample into sub-periods. Specifically, one of the worst market conditions for the buy-write strategy is February 2003 to November 2006, when the Russell 2000 experiences a high sustained growth at a relatively low volatility. Even in this market environment, we find that the buy-write strategy outperforms the Russell 2000 on a risk adjusted basis, returning two-thirds of the index return at half its volatility. We provide insight into the sources of the performance. On average, written calls end up in-the-money and transaction costs of writing the call at the bid further increases the losses. However, the buy-write strategy benefits by writing calls at an implied volatility higher than the realized volatility. In fact, we find that the contribution of the volatility risk premium - the difference between implied and realized volatility - is typically larger than the net losses incurred by the call position or the transaction costs. It appears that the existence of the risk premium is critical to the performance of the strategy. In fact, the (Leland's) alpha of the strategy is typically significantly smaller than the risk premium, implying that the buy-write strategy would not provide excess returns in the absence of the risk premium.
- Passive options-based investment strategies: The case of the CBOE S&P 500buy writeindex, Feldman, B. E., & Roy, D. (2005). Passive options-based investment strategies: The case of the CBOE S&P 500 buy write index.The Journal of Investing,14(2), 66-83. This article assesses the investment value of the CBOE S&P 500 BuyWrite (BXM) index and its covered call investment strategy to an investor from the total portfolio perspective. Whaley  finds risk-adjusted performance improvement based on the BXM index in individual comparison to the S&P 500. We replicate this work with a longer history for the BXM index and with the short but meaningful history of the Rampart Investment Management investable version of the BXM. We use the Stutzer  index and Leland's  alpha to assess risk-adjusted performance taking the skew and kurtosis of the covered call strategy into account. Additionally, we compare standard investor portfolios to portfolios where BXM has been substituted for large cap assets and find significant risk-adjusted performance improvement. The compound annual return of the BXM index over the almost 16-year history of this study is 12.39%, compared to 12.20% for the S&P 500. Risk-adjusted performance, as measured by the Stutzer index, is 0.22 for the BXM versus 0.16 for the S&P 500 (monthly). Leland's alpha is 2.81%/year. The tracking error of the Rampart investable version of the BXM (1.27%/year) is found to be credible evidence of the investability of the BXM index. Known sources of BXM return are reviewed and behavioral factors that may have enhanced BXM performance are considered.
- The efficiency of thebuy-writestrategy: Evidence from Australia, Mugwagwa, T., Ramiah, V., Naughton, T., & Moosa, I. (2012). The efficiency of the buy-write strategy: Evidence from Australia.Journal of International Financial Markets, Institutions and Money,22(2), 305-328. We examine the performance of the buy-write option strategy (BWS) on the Australian Stock Exchange and analyse whether such an investment opportunity violates the efficient market hypothesis on the basis of its risk and returns. This study investigates the relationship between buy-write portfolios returns and past trading volume and other fundamental financial factors including dividend yield, firm size, book to market ratio, earnings per share (EPS), price earnings ratio and value stocks within these portfolios. We also test the profitability of the buy-write strategy during bull and bear markets. Consistent with the literature, it is observed that BWS offers superior risk adjusted returns for low levels of out-of-moneyness and contrary evidence is observed for deeper out-of-money portfolios. Consistent with a preference for options with a maturity of around 3 months in Australia, this research shows that quarterly rebalancing periods offer better returns for the BWS.
- The performance of alternative futuresbuywritestrategies, Che, S. Y., & Fung, J. K. (2011). The performance of alternative futures buywrite strategies.Journal of futures markets,31(12), 1202-1227. This study compares the performance of a conventional buywrite (or covered call writing) and a dynamic buywrite strategy. The conventional strategy generally enhances portfolio returns in low volatility conditions but underperforms the underlying cash asset in sharply rising markets. The dynamic strategy adjusts the moneyness of the option according to market conditions. The study extends Hill, J. M., Balasubramanian, V., Gregory, K., and Tierens, I. (2006) and tests how and to what extent market volatility and market direction affect the performance of these two strategies. The study finds that both strategies offer significant positive , higher returns and lower standard deviations than the market. Consistent with prior research, the abnormal returns of the buywrite strategies can be attributed to a volatility premium embedded in the options prices. The buywrite returns from the Hong Kong market appear to be lower than those found in the U.S. and U.K. markets. The conventional buywrite outperforms the dynamic strategy in both high and low volatility environments, and in sharply falling markets. However, by targeting exercise probability, the dynamic strategy provides a greater upside in sharply rising markets.
- Buy writebenchmark indexes and the first options-based ETFs, Fulton, B. T., & Moran, M. T. (2008). Buy write benchmark indexes and the first options-based ETFs.ETFs and Indexing,2008(1), 101-110. A buy-write can be described as an investment strategy in which an investor buys stock(s) and writes covered call options for increased cash flows. In this decade investors have shown more interest in buy-writes for a number of reasons, including the fact that long-term risk and return characteristics of the buy-write strategy are easier to analyze because there now are 1) more buy-write studies by academics and consulting firms, and 2) benchmark indexes for buy-write performance such as the CBOE S&P 500 BuyWrite Index (BXM). Sometimes sluggish performance of traditional assets such as stocks and bonds has led to more investors seeking alternative investments that have delivered good cash flows and strong risk-adjusted returns, even if the alternatives tend to underperform stocks in bull markets. Over a period of almost 22 years dating back to June 30, 1986, the BXM Index had returns close to those of the S&P 500 Index, but with only 69% of the volatility of the S&P 500 Index. Key sources of return for the BXM Index include the facts that the BXM Index took in options premiums at a rate of more than 1.6% per month, and the index options often were richly priced, with implied volatility usually being higher than the realized volatility for the index options. The recent introduction of two ETFs-the PowerShares S&P BuyWrite Portfolio (PBP) and PowerShares NASDAQ-100 BuyWrite Portfolio (PQBW)-give investors more flexibility as they explore possibilities for implementing the buy-write strategy for their investment portfolios.