OPTION STRATEGIES
So Many Options, So Little Time
Does Consecutive Covered Call Writing Beat Buy & Hold?
by Gunter Meissner and Sandra Wu
One of the most popular option strategies meets one of the
most popular investing methods -- which will win?
One of the most popular option strategies
is covered call writing. In this strategy, the investor owns the underlying
asset, say a stock, and sells a call option on the asset. The investor
believes the stock will move sideways during the option period. In this
case, the call premium is earned as additional income. In this article
we test whether a consecutive covered call writing strategy outperforms
the buy & hold strategy.
THE COVERED CALL WRITING STRATEGY
The covered call writing strategy (CCW) consists of two positions: Holding
the underlying asset and selling a call on the underlying. Graphically,
this can be expressed as in Figure 1, where the underlying asset is a stock.
FIGURE 1: EXAMPLE OF A COVERED CALL WRITING STRATEGY (CCW).
The covered call writing strategy outperforms holding the stock if
the price stays below the strike price plus the call premium, which in
this case is 110.
The covered call writing strategy outperforms holding the stock
if the stock price stays below the strike price plus the call premium,
which in this case is 100 + 10 = 110. (For ease of explanation, in Figure
1 we ignored the interest rate effect of receiving the call premium at
option start and paying a potential payoff later at option maturity.) However,
a drawback of the CCW strategy is that it misses out on strong price gains.
If the stock price is above 110, the CCW strategy is inferior to just holding
the stock. In this case, the underlying is called away at the strike price
of 100 and the received call premium of 10 cannot compensate for the strong
increase in the stock price above 110. Another drawback of the CCW strategy
is that losses occur if the underlying asset drops sharply, since you own
the underlying.
THE METHOD AND DATA
In our study, we examined one-month and two-month calls on the Standard
& Poor's 500 (SPX). We observed 35 years of data, from January 1970
to December 2004. As rollover dates for the call options, we chose the
maturity date of the calls on the S&P 500, which is every third Friday
of the month. We derived the historical implied volatility from the volatility
index (VIX), which represents data of option prices of the S&P 500.
We input the VIX implied volatility into a Black-Scholes model to derive
the call option prices (a model can be found at www.dersoft.com/Black76.xls).
The dividend yield for the S&P 500 was generated from Bloomberg.
...Continued in the May issue of Technical Analysis of STOCKS &
COMMODITIES
Excerpted from an article originally published in the May 2006 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2006, Technical Analysis, Inc.
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