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15YearsoftheRussell2000BuyWrite

September15,2011

NikunjKapadia1andEdwardSzado2,CFA

CISDMgratefullyacknowledgesresearchsupportprovidedbytheOptionsIndustryCouncil.
Researchresults,however,representthoseoftheauthorsanddonotnecessarilyrepresentthe
viewsoftheOIC.WethankPhilGockeforcommentsandsuggestions.Pleaseaddress
correspondencetoEdwardSzado,CISDM,UniversityofMassachusetts,Amherst,MA01003,
4135773166,oremail:ed@cisdm.org.

AssociateProfessorofFinance,IsenbergSchoolofManagement,UniversityofMassachusetts,Amherst,MA
01003.
2
ResearchAssociate,CISDM,IsenbergSchoolofManagement,UniversityofMassachusetts,Amherst,MA01003.

Electronic copy available at: http://ssrn.com/abstract=1928822

Abstract

UsingdatafromJanuary18,1996toMarch31,2011,weconstructandevaluatereturnsona
buywritestrategyontheRussell2000index.Theresultsdemonstratethatthestrategyhas
consistentlyoutperformedtheRussell2000indexonariskadjustedbasis,whenimplemented
withonemonthtoexpirationcallsandwhenperformanceisevaluatedusingstandard
performancemeasures.Overthe182monthperiodofanalysis,theRUTbuywritestrategy
using2%outofthemoney,onemonthcallsgeneratedhigherreturnsthantheunderlying
index(8.87%versus8.11%)ataboutthreequartersofthestandarddeviation(16.57%versus
21.06%).Theoutperformanceisrobusttomeasureswhichspecificallyconsiderthenonnormal
distributionofthestrategy'sreturns.However,theconsistentperformanceadvantagedoesnot
remainifweutilizetwomonthtoexpirationcalls.Toevaluatetheperformanceinvarying
marketconditions,webreakoursampleintosubperiods.Specifically,oneoftheworstmarket
conditionsforthebuywritestrategyisMarch2003toOctober2007,whentheRussell2000
experiencesahighsustainedgrowthatarelativelylowvolatility.Eveninthismarket
environment,wefindthatthe2%outofthemoneyonemonthbuywritestrategy
outperformstheRussell2000onariskadjustedbasis,returningalmostthesamereturnsasthe
indexreturnatthreequartersitsvolatility.Weprovideinsightintothesourcesofthe
performance.Onaverage,theexpirationvalueofwrittencallsexceedsthepremiumcollected
andthetransactioncostsofwritingthecallatthebidfurtherincreasesthelosses.However,
thebuywritestrategybenefitsbywritingcallsatanimpliedvolatilitythatisgenerallyhigher
thantherealizedvolatility.Infact,wefindthatthecontributionofthevolatilityriskpremium
thedifferencebetweenimpliedandrealizedvolatilityistypicallylargerthanthenetlosses
incurredbythecallpositionorthetransactioncosts.Itappearsthattheexistenceoftherisk
premiumiscriticaltotheperformanceofthestrategy.Infact,the(Leland's)alphaofthe
strategyistypicallysignificantlysmallerthantheriskpremiumimplyingthatthebuywrite
strategywouldnotprovideexcessreturnsintheabsenceoftheriskpremium.

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Electronic copy available at: http://ssrn.com/abstract=1928822

Introduction
ThepurposeofthisstudyistoupdatetheresultsofKapadiaandSzado[2007],TheRiskand
ReturnCharacteristicsoftheBuywriteStrategyontheRussell2000Indextoinclude
performancethroughtherecentfinancialcrisis3.Theinitialstudyincludedapproximately10
yearsofdatafromJanuary19,1996throughNovember17,2006.Thisnewstudyaddsalmost
fiveyearsofdata,extendingtheanalysisthroughMarch31,20114.
Thepurposeofthispaperistoassesstheriskandreturncharacteristicsofabuywrite(covered
call)strategyontheRussell20005.Theequityindexbuywritestrategyentailsthewritingofa
callonanequityindexagainstalongpositioninthecorrespondingunderlyingequityindex.A
buywriteisutilizedasareturnenhancementstrategy,althoughtheextracashflowfromcall
writingdoesproducesomeriskmitigationbyprovidingacushionagainstlossesinthe
underlying.Typically,thebuywritestrategywouldbeimplementedpassively,without
attemptingtotimethemarket.Theoriginalpaper(KapadiaandSzado[2007])wasmotivated
bythegrowinginterestintheuseofbuywritestrategiesforinvestmentpurposes.Theinterest
wasreflectedinCBOEsintroductionofanumberofbuywriteindicesbasedonavarietyof
equityindicessuchastheS&P500,theDowJonesIndustrialAverage,theNASDAQ100andthe
Russell2000.Althoughanumberofpapershaveexaminedthereturnsonthestrategyforthe
S&P5006,theriskandreturncharacteristicsofthebuywritestrategyontheRussell2000has
notbeenextensivelyexamined.Previousstudieshaveconsistentlyfoundthatthebuywrite
strategyontheS&P500outperformedtheS&P500onariskadjustedbasispriortothe
financialcrisis.Itiscertainlyworthwhiletodeterminewhethertheresultsassociatedwiththe
earlierpapersarerobustacrossotherindicesandacrossvaryingmarketconditions,including
thefinancialcrisis.Thefinancialcrisishasprovidedabackdropfortestingthestrategyin
particularlyturbulenttimes.Moregenerally,theanalysisofthereturnsofthebuywrite
strategyalsoallowsusinsightintohowoptionsarepricedandtradedinthemarket.Ifthe
assumptionsunderlyingtheBlackScholesanalysisheldprecisely,itwouldbestraightforwardto
understandthereturnsofabuywritestrategy.Inpractice,however,thereturnsareimpacted
bybothtransactioncostsandtheactualmarketvalueoftheoptions,whichtendstobehigher
thanthepricessuggestedbytheBlackScholesformula.Thispricedifferentialmanifestsitselfin

Itisworthnotingthattheresultsinthispapervarysomewhatfromtheoriginalpaperduetosubsequentdata
cleaningbyOptionmetricsandsomesmallchangesinmethodologyoutlinedinthebodyofthepaper.
4
TheanalysisisbasedonmonthlyreturnsfortheperiodofFebruary1,1996toMarch31,2011.
5
TheRussell2000(RUT)wasutilizedfortheoriginalstudyratherthanthemoreeasilyinvestableiSharesRussell
2000Indexexchangetradedfund(IWM)duetothemuchlongeravailabletimeseriesoftheRUT.
6
SeeWhaley(2002),FeldmanandRoy(2004),RenickerandMallick(2005),andHilletal(2006).

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impliedvolatilitiesthatareconsistentlyhigherthanrealizedhistoricalvolatilities7.Ourobjective
istousetheanalysisofthebuywritestrategytoprovideinsightintotheeconomicimportance
ofthesepotentiallyoffsettingeffects.Whiletheoriginalstudyprovidedacomprehensive
analysisofthebuywritestrategyfortheRussell2000overtheperiodfromJanuary19,1996to
November17,2006,thisupdateextendstheanalysisthroughtoMarch31,2011.Thelengthof
thesampleperiodallowsustoassesstheperformanceindifferentmarketconditions.In
addition,weprovideacomparisonofthestrategyoverarangeofimplementationswith
differingcallstrikesandmaturities.Consistentwiththepreviousliterature,wefindthatthe
buywritestrategymayoutperformtheindex.However,theperformancedependsonthe
optionselectioncriteriaoftheparticularimplementation.Wefindthattheonemonthtwo
percentOTMstrategyoutperformstheindexusingavarietyofmeasures.Overthe182month
periodofanalysis,theRUTbuywritestrategyusing2%OTM,onemonthcallsgenerateda
higherreturnthantheunderlyingindex(8.87%versus8.11%)ataboutthreequartersofthe
standarddeviation(16.57%versus21.06%).Moresignificantly,itoutperformstheindexin
possiblytheworstmarketenvironmentforthestrategy,whentheindexexperienceslarge
sustainedpositivereturnswithlowvolatility.Overthe56monthperiodfromMarch2003to
October2007,theRussell2000hadanannualizedreturnof20.92%andavolatilityof14.08%.
Eveninthisunfavorablemarketenvironment,the2%OTMbuywritestrategyreturnedalmost
thesamereturnastheRussell2000atabouttwothirdsthelatter'svolatility,easily
outperformingthemarketbystandardmeasures.Asmentionedearlier,theselectioncriteria
forthecallsareimportantindeterminingthestrategy'sreturns.Thisisthecasebecauseboth
transactioncostsandthevolatilityriskpremium(thepremiumofimpliedvolatilityoverrealized
volatility)haveasignificantimpactonreturns,andthemagnitudeofboththesefactorsvaries
significantlyacrossoptionswithdifferingmoneynessandtimetoexpiration.Infact,therisk
premiumofthecalliscriticaltothereturnsofthestrategyasourresultssuggestthatthe
strategywouldnotoutperformtheindexifoptionswerepricedatrealizedvolatility.Overall,
wefindthatthebuywritestrategycanoutperformtheunderlyingindex.However,both
transactioncostsandthechoiceoftheoptioncontractarecentralfactorsindeterminingthe
performance.
DataandMethodology
Forthisupdateandfortheoriginalstudy,weutilizedoptiondatafromOptionmetrics.The
datasetcomprisesofclosingbidsandoffersofalloptionsandindicesquotedacrossallthe
exchangesfortheperiodfromJanuary1996throughMarch2011.TheOptionmetricsdataalso
providesuswithcomputedimpliedvolatilities.ThereturnsontheRussell2000arecombined

ThemeasureddifferentialassumesthedistributionalassumptionsoftheBlackScholesmodel.Impliedvolatilities
aremeasuredbasedontheBlackScholesmodel.Iflognormalitydoesnothold,bothrealizedandimplied
volatilitiesmaysufferfrommeasurementerrors.

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withadailycashdividendtocreateatotalreturnindex.ThedailytotalreturnoftheRussell
2000indexiscalculatedas:

Dailydataisutilizedtoallowustocreatedailybuywritestrategyreturns.Whiletheoriginal
studycalculatedmonthlyreturnsfromexpirationtoexpiration,thisupdatecalculatesmonthly
returnsfrommonthendtomonthendtomorecloselymatchthetypicalfocusofinvestors.The
Russell2000totalreturnindex,combinedwiththereturnsoftheshortcallpositions,
determinesthereturnsofourbuywritestrategy.Fortheanalysis,weconstructabuywrite
index,closelyfollowingthemethodologyinWhaley(2002).TheCBOEindicesarealsobasedon
asimilarmethodology.Detailsoftheindexconstructionareasfollows:Onceeachmonth,at
thecloseonthedaybeforetheexpiringoptionsettles(usuallythethirdThursdayofthe
month),anewcalliswritten.
Onthebusinessdayfollowingthedayanewcalliswritten8,thebuywritereturniscalculated
as:

Onthedayanewcalliswritten(andanoldcallpositionisclosed),thebuywritereturnis
calculatedas:

Onallotherdays,thebuywritereturniscalculatedas:

Inordertoperformtheanalysisonmonthlydata,monthlyreturnseriesareconstructedfrom
thedailyreturnseriesforeachbuywriteimplementation.
Wecompareseveraldifferentimplementationsoftheindex.First,foreachmaturity,we
construct5indicescorrespondingtotheatthemoney(ATM)aswellas2%and5%inthe
money(ITM)callsandoutofthemoneycalls(OTM),respectively.Weusetwodifferent
maturities,onemonthandtwomonth,sothatwehaveatotalof10indices.Themainbodyof
thepaperincludestheresultsfortheonemonthstrategies.Theresultsforthetwomonth
implementationsareprovidedintheappendix.Forallstrategies,theoptionishelduntil

Inordertocapturetransactioncosts,wewritethenewcallatthebidprice.

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expiration9.Theshortcallpositionisclosedattheintrinsicvalueofthecall.Thereisaslight
inaccuracyimposedbythisprocedure.Althoughinpractice,thecallissettledbasedonthe
Russell2000componenttradepricesonthemorningofthedaybeforeexpiration,weare
effectivelysettlingtheoptionsbasedontheclosingpricesofthepreviousday.Wedothis
becauseouroptionsdatasetdoesnotincludeopeningprices.Inordertoincludea
representationoftransactioncosts,thenewcalliswrittenatthecurrentbid.Foralldays
betweentherollindateforthenewcallandtherollout(expiration)ofthecall,thecallis
markedtomarketforreturncalculationsatthemidpointbetweenthebidandtheask.In
performingouranalysis,wefaceadatalimitationinthatbidaskquotesacrossallstrikesare
notavailableovertheentireperiod(althoughthedataavailabilityimprovessignificantlyin
morerecentyears).Toensurethattheindexisrepresentativeofactualcloseandbidask
prices,weonlyuseoptionswhichhaveafullsetofbidaskclosepricesavailableovertheir
holdingperiod.Itisworthnotingthatthisputsagreaterrestrictionontheavailabledatathan
theoriginalstudyinwhichweonlyrequirepricesonrolldates.
Sinceoptionstrikepricesarenotcontinuous,theavailablestrikesarenotexpectedtoexactly
matchthedesiredmoneyness.Whenaspecificoptionquoteisnotavailable,wesubstituteit
withtheoptionofthenearestavailablestrike10.Exhibit1aprovidesdetailsoftheaverage
deviationfromthedesiredstrike,bothasapercentageoftheunderlyinglevelandonan
absolutebasis.

Exhibit1a:DeviationofUtilizedStrikesfromCalculatedStrikes
1MonthCallBuyWrite
5%OTM 2%OTM

ATM

2%ITM

5%ITM

Overall

AveragePercentage
Deviation

0.30%

0.03%

0.01%

0.03%

0.14%

0.03%

AverageDeviation

1.35

0.14

0.14

0.06

0.52

0.23

ATM

2%ITM

5%ITM

Overall

2MonthCallBuyWrite
5%OTM 2%OTM
AveragePercentage
Deviation

0.28%

0.05%

0.04%

0.04%

0.21%

0.02%

AverageDeviation

1.36

0.16

0.31

0.45

0.75

0.24

Morespecifically,thecallpositionisclosedattheclosepriceontheafternoonbeforethemorningexpiration
settlement.
10
Intheoriginalstudy,foroutofthemoneycalls,wesubstitutedthenextavailablestriketowardstheatthe
money.FortheATMcalls,weusedtheclosestavailablestrike.

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Onaverage,acrossalltheonemonthindicesweconstruct,theaveragepercentagedeviation
was0.03%fromthedesiredstrike(seeExhibit1a).However,themagnitudeofdeviationfrom
thedesiredstrikevariesacrossthedifferentstrategyimplementationsandovertime.Exhibits
1band1cprovidethetimeseriesofthedeviationsovertheperiodofanalysisfortheone
monthandtwomonthstrategies,respectively.TheonemonthATMstrategyisthemostpure
ofthebuywritestrategiesweconsider,withameandeviationfromthedesiredstrikeof0.01%
oftheunderlying.Itisworthnotingthatthedeviationsfromthedesiredstrikesarearesultof
discretestrikesaswellasdatalimitations.Quotesarenotalwaysavailablefortheallofthe
actualdiscretestrikesresultingintheuseoftheclosestavailablestrike.Inapractical
applicationofthesestrategies,onewouldnotencounterthesequoteavailabilitylimitations.
Thestrategycouldbeimplementedatthediscretestrikenearestthecalculatedstrike,sincethe
marketwouldprovidetherequiredquotes.
Thereturnsofthestrategywillbeimpactedbybothtransactioncostsaswellasanyconsistent
deviationoftheimpliedvolatilityfromthehistoricalrealizedvolatility.Theprimarytransaction
costassociatedwiththeimplementationofthestrategyisthebidaskspreadoftheoption.To
understandtheimpactofthebidaskspreadaswellastoallowforthepossibilitythatacall
maybewrittenwithinthespread,wecalculatethereturnsusingtwodifferentprocedures.In
thefirst,weassumethecallsarewrittenatthebid.Inthesecondweassumethecallsare
writtenatthemidpointbetweenthebidandask.

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Jan96

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Mo205%OTM

Mo202%OTM

Mo20ATM

Mo202%ITM

Mo205%ITM

Jan11

Aug10

Mar10

Oct09

May09

Dec08

Jul08

Feb08

Mo102%ITM

Sep07

Apr07

Nov06

Jun06

Jan06

Aug05

Mo10ATM

Mar05

Oct04

May04

Dec03

Jul03

Mo102%OTM

Feb03

Sep02

Apr02

Nov01

Jun01

Jan01

Aug00

Mo105%OTM

Mar00

Oct99

May99

Dec98

Jul98

Feb98

Sep97

Apr97

Nov96

Jun96

InitialPercentITM

Jan96

Jan11

Aug10

Mar10

Oct09

May09

Dec08

Jul08

Feb08

Sep07

Apr07

Nov06

Jun06

Jan06

Aug05

Mar05

Oct04

May04

Dec03

Jul03

Feb03

Sep02

Apr02

Nov01

Jun01

Jan01

Aug00

Mar00

Oct99

May99

Dec98

Feb98
Jul98

Sep97

Apr97

Nov96

Jun96

InitialPercentITM

Exhibit1b:TimeSeriesofInitialMoneynessofUtilizedStrikes,OneMonthCalls

InitialMoneynessbyTargetMoneyness:1MonthCalls

10.0

5.0

0.0

5.0

10.0

15.0

Mo105%ITM

Exhibit1c:TimeSeriesofInitialMoneynessofUtilizedStrikes,TwoMonthCalls

8.0

InitialMoneynessbyTargetMoneyness:2MonthCalls

6.0

4.0

2.0

0.0

2.0

4.0

6.0

8.0

Exhibit2:Growthof$100inthe1Month2%OTMBuywriteStrategy,ConsideringDifferent
TreatmentsofTransactionsCosts

1Month2%OTMBuyWriteGrowthof$100
$450
$400
$350
$300
$250
$200
$150

RUTTR

BuyWrite(SellatBid)

Feb11

Aug10

Feb10

Feb09

Aug09

Feb08

Aug08

Feb07

Aug07

Feb06

Aug06

Feb05

Aug05

Feb04

Aug04

Feb03

Aug03

Feb02

Aug02

Aug01

Feb01

Feb00

Aug00

Aug99

Feb99

Feb98

Aug98

Feb97

Aug97

Feb96

Aug96

$100

BuyWrite(SellatMidofBid/Ask)

Exhibit2providesagraphicalpresentationofthecumulativeimpactofthedifferencebetween
thesetwotreatmentsforthe1month2%OTMbuywritestrategy.ItisevidentfromExhibit2
thatifwedisregardtransactioncosts,thecumulativegrowthoftheATMbuywritestrategy
overthe15yearsofourstudyfarsurpassesthatoftheRussell2000,withlessvolatility.The
significanceoftheimpactoftransactioncostsisalsoquiteclear.Exhibits3aand3bprovide
detailsonthemagnitudeoftransactionscostsasapercentageoftheunderlyingprice.

Exhibit3a:BidaskSpreadsandVolatilityDifferentials

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AverageBid/AskSpread(as%ofUnderlying)
5%OTM 2%OTM

ATM

2%ITM

5%ITM

1Month

0.12%

0.15%

0.19%

0.24%

0.30%

2Month

0.17%

0.23%

0.26%

0.31%

0.34%

AverageVolatilitySpread(ImpliedMinusRealized)
5%OTM 2%OTM

ATM

2%ITM

5%ITM

1Month

1.4%

2.5%

3.4%

4.6%

6.4%

2Month

1.5%

2.4%

3.4%

4.3%

5.6%

Exhibit3b:BidaskSpreadsas%ofUnderlyingLevelTimeSeries,1MonthBuywrite
Bid/AskSpreadas%ofUnderlying
0.90%
0.80%

Bid/AskSpread

0.70%
0.60%
0.50%
0.40%
0.30%
0.20%
0.10%

2/1/2011

9/1/2010

4/1/2010

6/1/2009

11/1/2009

1/1/2009

8/1/2008

3/1/2008

5/1/2007

10/1/2007

7/1/2006

12/1/2006

2/1/2006

9/1/2005

4/1/2005

6/1/2004

11/1/2004

1/1/2004

8/1/2003

3/1/2003

5/1/2002

10/1/2002

7/1/2001

12/1/2001

2/1/2001

9/1/2000

4/1/2000

6/1/1999

11/1/1999

1/1/1999

8/1/1998

3/1/1998

5/1/1997

10/1/1997

7/1/1996

12/1/1996

2/1/1996

0.00%

ExpirationDate
1Month5%OTM

1Month2%OTM

1MonthATM

Theaverageinitialbidaskspread11asapercentageoftheunderlyingpricefortheonemonth
strategiesrangefrom0.12%to0.30%,smallerforcallsthatarefurtherOTM.Thepercentage
spreadsforthetwomonthoptionsarehigherthanthosefortheonemonthoptions,ranging
from0.17%to0.34%.Thespreadsforthe2%OTMonemonthandtwomonthstrategies(the
mainoptionsofinterest)are0.15%and0.23%,respectively12.Toputthesenumbersin

11

Thebidaskspreadquotedonthedayonwhichthecallsarewritten.Thisdoesnotincludespreadson
subsequentdays.
12
WhiletheoriginalstudyfocusedontheATMstrategies,theupdatefocusesonthe2%OTMstrategiestobe
consistentwithotherliterature(seeforexample,SzadoandSchneeweis[2010]).

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perspective,a2%OTMonemonthbuywrite,wouldincurtransactionscostsofapproximately
0.9%peryear13ifthecallsarewrittenatthebidprice.
Exhibit3c:BidaskSpreadsas%ofUnderlyingLevelTimeSeries,2MonthBuywrite
Bid/AskSpreadas%ofUnderlying
1.20%

1.00%

Bid/AskSpread

0.80%

0.60%

0.40%

0.20%

2Month2%OTM

2MonthATM

2Month2%ITM

2Month5%ITM

3/1/2011

5/1/2010

10/1/2010

7/1/2009

12/1/2009

2/1/2009

9/1/2008

4/1/2008

6/1/2007

11/1/2007

1/1/2007

8/1/2006

3/1/2006

5/1/2005

10/1/2005

7/1/2004

12/1/2004

2/1/2004

9/1/2003

4/1/2003

6/1/2002

11/1/2002

1/1/2002

8/1/2001

3/1/2001

5/1/2000

2Month5%OTM

10/1/2000

7/1/1999

12/1/1999

2/1/1999

9/1/1998

4/1/1998

6/1/1997

11/1/1997

1/1/1997

8/1/1996

3/1/1996

0.00%

ThetimeseriesofthespreadsareprovidedinExhibits3band3c.Whilespreadshavedecreased
substantiallyovertime,theyexperiencedsignificantpositivespikesduringthefinancialcrisis.
Onewouldexpectthegeneraltrendtowardlowertransactioncostsaswellasthespikesin
transactioncostsduringthecrisistohavesignificantimpactsontheprofitabilityofthebuy
writestrategy.
AshasbeendocumentedintheliteratureforoptionsontheS&P500(forexample,seeBakshi
andKapadia[2003]),theBlackScholesimpliedvolatilityisconsistentlyhigherthanthehistorical
realizedvolatilityovertheremaininglifetimeoftheoption.Theaveragerealizedvolatilityrisk
premium(definedastheimpliedvolatilitylesstherealizedvolatility)is2.5%and2.4%forthe
2%OTMstrategiesfortheonemonthandtwomonthtimestoexpiration,respectively.Since
thisisoneofthedriversofthebuywritestrategyreturns,thevolatilityriskpremiumwouldbe
expectedtohelpprovideafavorableenvironmentfortheimplementationofthestrategy.
Whilethedifferentialbetweenimpliedvolatilityandrealizedvolatilityisgenerallypositive,as
Exhibit4aand4bindicate,therealizeddifferentialvariesconsiderablyovertimeandisattimes
significantlynegative.Thisisparticularlythecasewhenrealizedvolatilityexhibitssudden
upwardspikes.

13

ofthebidaskspreadforeachofthe12months=0.5*0.15%*12.

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Exhibit4a:RealizedVolatilityDifferentials,1MonthBuywrite
ImpliedVolatilitySpreadoverRealizedVolatility
100%
80%
60%

Volatility

40%
20%
0%
20%
40%
60%

2/1/2011

9/1/2010

4/1/2010

6/1/2009

11/1/2009

1/1/2009

8/1/2008

3/1/2008

5/1/2007

10/1/2007

7/1/2006

12/1/2006

2/1/2006

9/1/2005

4/1/2005

6/1/2004

11/1/2004

1/1/2004

8/1/2003

3/1/2003

5/1/2002

10/1/2002

7/1/2001

12/1/2001

2/1/2001

9/1/2000

4/1/2000

6/1/1999

11/1/1999

1/1/1999

8/1/1998

3/1/1998

5/1/1997

10/1/1997

7/1/1996

12/1/1996

2/1/1996

80%

ExpirationDate
RealizedVolatility

1Month5%OTM

1Month2%OTM

1MonthATM

1Month2%ITM

1Month5%ITM

Exhibit4b:RealizedVolatilityDifferentials,2MonthBuywrite
ImpliedVolatilitySpreadoverRealizedVolatility
100%
80%
60%

Volatility

40%
20%
0%
20%
40%

3/1/2011

5/1/2010

10/1/2010

12/1/2009

7/1/2009

2/1/2009

9/1/2008

4/1/2008

6/1/2007

11/1/2007

1/1/2007

8/1/2006

3/1/2006

5/1/2005

10/1/2005

12/1/2004

7/1/2004

2/1/2004

9/1/2003

4/1/2003

6/1/2002

11/1/2002

1/1/2002

8/1/2001

3/1/2001

5/1/2000

10/1/2000

12/1/1999

7/1/1999

2/1/1999

9/1/1998

4/1/1998

6/1/1997

11/1/1997

1/1/1997

8/1/1996

3/1/1996

60%

ExpirationDate
RealizedVolatility

2Month5%OTM

2Month2%OTM

2MonthATM

2Month2%ITM

2Month5%ITM

RiskandReturnCharacteristics
FullSampleResults
Exhibit5providessummarystatisticsfortheonemonthbuywritestrategyfortheentire
sampleperiodfromFebruary1,1996toMarch31,2011.Inaddition,Exhibit6providesa
graphicalpresentationoftheperformanceovertheperiod.Wereportbothannualizedreturns
andannualizedstandarddeviationsforeachstrategyimplementation.Asthereturnsonthe
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buywritestrategyarenotnormallydistributed14,wealsoreportthehighermomentsofthe
distributionincludingtheexcesskurtosisandtheskewness.Sincestandarddeviationmaynot
beaneffectivemeasureofriskfornonnormaldistributions,wereportalternativemeasures
suchastherangeoftherealizedreturndistributionandthemaximumdrawdownandrunup.
Tobeconsistentwithextantliterature,wereportstandardriskadjustedperformancemeasures
includingtheSharperatio,Treynorratio,andJensensalpha.Sincethesemeasuresarenot
robusttononnormalreturndistributions,wealsoreporttworobustriskadjustedperformance
measures:theStutzerindexandLelandsalpha.
Inwhatfollows,wewillfocusmostlyonthestrategyforthe2%OTMonemonthbuywrite
althoughwecontinuetoreportthenumbersforotherstrikes.Detailsforalltwomonth
strategiesareprovidedintheappendix.Theannualizedreturnforthe2%OTMonemonth
strategyoverthe182monthsofoursampleperiodis8.87%comparedtotheRussell2000
returnof8.11%.Itisofgreatinterestthatthevolatilityofthestrategyforthe2%OTMbuy
writeismuchlowerthanthatoftheindex.Theannualizedstandarddeviationforthe1month
2%OTMbuywritestrategyis16.57%comparedto21.06%fortheRussell2000.However,the
meanreturnandvolatilityarenotsufficienttocharacterizethedistributionofreturnssincethe
buywritestrategy'sreturndistributionwouldbenonnormaleveniftheunderlyingRussell
2000distributionwasnormal15.Thebuywritestrategy'sreturnsaresignificantlymorefat
tailedandnegativelyskewedthanthereturnsoftheindex.Theexcesskurtosisandthe
skewnessofthe2%OTMstrategyare3.49and1.40comparedwith0.81and0.56forthe
underlyingindex.
Giventhatthereturndistributionisnonnormal,itisparticularlyimportanttoconsider
measuresofriskotherthanvolatility.Exhibit5reportstheminimummonthlyreturnandthe
maximumdrawdownoverthefullperiod.Theworstmonthlyreturnforthe2%OTMstrategyis
18.69%,whichisbetterthantheworstmonthlyreturnof20.80%fortheRussell2000.The
largestdrawdownforthe2%OTMstrategyis42.9%,comparedwiththemaximumdrawdown
of52.9%fortheindex.Conversely,thebestmonthlyreturnisfarhigherfortheindexat
16.51%,comparedwith9.68%forthe2%OTMstrategy.Incontrast,themaximumrunupis
lowerfortheindexat226.2%,comparedwith264.7%forthe2%OTMstrategy.These
measuressuggestthatthebuywritestrategyhadalowerrealizedriskoverthisperiodwhen
comparedtotheunderlyingindex.Thisargumentisfurthersupportedbythebuywrites
Lelandbetaof0.74.Fromariskadjustedperformanceperspective,theSharperatioand
Treynorratiosuggestthatthe2%OTMbuywriteoutperformedtheRussell2000overthe

14

Sincethebuywritestrategyessentiallytruncatestheupperendofthereturndistribution,onewouldexpectthe
returnstobenonnormal.
15
Fordetailsofthenonnormalityofthereturndistributionsseetheoriginalstudy.

13|P a g e

periodofstudy.TheSharperatiois0.33forthebuywriteand0.23fortheunderlyingindex.
Similarly,theTreynorratiosare0.08and0.05,respectively.

Exhibit5:1MonthBuywriteStrategySummaryStatistics,FullPeriod
1MonthCallBuyWrite Russell
Feb1,1996toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

8.11%
21.06%
0.56
0.81
1.00
0.23
0.05
0.21
1.00
1.00
0.84%
1.68%
20.80%
16.51%
52.9%
226.2%
38%
62%
182

5%OTM 2%OTM
10.21%
18.63%
1.04
1.85
0.96
0.37
0.08
0.33
0.84
0.21%
0.86
0.20%
0.96%
1.74%
18.86%
10.57%
46.0%
337.1%
36%
64%
182

8.87%
16.57%
1.40
3.49
0.92
0.33
0.08
0.30
0.72
0.15%
0.74
0.14%
0.83%
1.77%
18.69%
9.68%
42.9%
264.7%
33%
67%
182

ATM

2%ITM

5%ITM

7.30%
14.66%
1.76
5.45
0.87
0.27
0.07
0.24
0.60
0.06%
0.63
0.05%
0.68%
1.62%
17.84%
10.16%
37.7%
193.0%
31%
69%
182

6.94%
13.24%
2.16
8.15
0.81
0.27
0.07
0.24
0.51
0.07%
0.53
0.06%
0.64%
1.33%
17.69%
10.01%
34.8%
178.0%
27%
73%
182

5.54%
10.99%
2.72
12.37
0.72
0.20
0.06
0.18
0.38
0.01%
0.40
0.00%
0.50%
0.91%
16.43%
8.26%
31.3%
130.7%
23%
77%
182

Asmentionedearlier,thesemeasuresarenotrobustagainstadeviationfromnormality.For
thisreason,LelandsalphaandtheStutzerindexarepresented.Theformerisarobust
alternativeforJensen'salphaandthelatterisanalternativefortheSharperatio.The2%OTM
buywriteexhibitedapositive0.15%monthlyLelandalphaovertheperiodofstudy(risk
adjustedperformanceabovetheRussell2000).Inaddition,theStutzerindexofthebuywriteis
significantlygreaterthanthatoftheRussell2000(0.30and0.21,respectively).

14|P a g e


Exhibit6:1MonthBuywriteStrategyGrowthof$100,FullPeriod

1MonthBuyWriteGrowthof$100
$500
$450
$400
$350
$300
$250
$200
$150

RUTTR

ATM

5%OTM

Feb11

Feb10

Aug10

Feb09

Aug09

Feb08

Aug08

Feb07

Aug07

Feb06

Aug06

Feb05

2%OTM

Aug05

Feb04

Aug04

Feb03

Aug03

Feb02

Aug02

Feb01

Aug01

Feb00

Aug00

Feb99

Aug99

Feb98

Aug98

Feb97

Aug97

Feb96

Aug96

$100

Exhibit7illustratesthe24monthrollingaverageannualizedreturnsofthe2%OTMbuywrite
strategy.WhiletheabsoluteperformancegapbetweenthebuywriteandtheRussell2000
fluctuatessignificantly,thegapisoftenextremelysmall.Incontrast,Exhibit8showsarelatively
consistent24monthrollingannualizedstandarddeviationgapbetweenthebuywriteandthe
Russell2000,withthe2%OTMbuywritetypicallyexhibitinga5to7%lowerrollingvolatility.

15|P a g e

16|P a g e

RUTTR

ATM
2%OTM

2%OTM

5%OTM

Apr09
Sep09
Feb10
Jul10
Dec10

ATM

Dec05
May06
Oct06
Mar07
Aug07
Jan08
Jun08
Nov08

RUTTR

Aug02
Jan03
Jun03
Nov03
Apr04
Sep04
Feb05
Jul05

Apr99
Sep99
Feb00
Jul00
Dec00
May01
Oct01
Mar02

Jan98
Jun98
Nov98
Jan98
Jun98
Nov98
Apr99
Sep99
Feb00
Jul00
Dec00
May01
Oct01
Mar02
Aug02
Jan03
Jun03
Nov03
Apr04
Sep04
Feb05
Jul05
Dec05
May06
Oct06
Mar07
Aug07
Jan08
Jun08
Nov08
Apr09
Sep09
Feb10
Jul10
Dec10

Exhibit7:24MonthRollingAnnualizedReturns

24MonthRollingAnnualizedReturn

60%

50%

40%

30%

20%

10%

0%

10%

20%

30%

40%

5%OTM

Exhibit8:24MonthRollingAnnualizedStandardDeviation

24MonthRollingAnnualizedStandardDeviation

35%

30%

25%

20%

15%

10%

5%

0%

Theperformanceofthebuywritestrategyissensitivetomarketconditions.Inparticular,we
expectthestrategytounderperformrelativetotheindexinastrongupwardtrendingmarket
whichconsistentlymovesthroughthestrikepriceofthewrittencallatlowvolatility.To
observetheimpactofvaryingmarketconditionsontheperformanceofthebuywrite,wesplit
theoveralldataperiodintothreesubperiods:February1,1996toFebruary28,2003;March1,
2003toOctober31,2007;andNovember1,2007toMarch31,2011.Thebreakpointswere
chosenspecificallytocapturethestrongandsteadyfourplusyearrunuptheRussell2000
experiencedfromitslocalminimuminMarch2003toitslocalprecrisismaximuminOctober
2007(ascanbeobservedinExhibit2)aswellasisolatingthefinancialcrisis.

Exhibit9:1MonthBuywriteStrategySummaryStatistics,FavorablePeriod
1MonthCallBuyWrite Russell
Feb1,1996toFeb28,2003
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

17|P a g e

3.28%
21.83%
0.39
0.50
1.00
0.06
0.01
0.06
1.00
1.00
0.47%
0.91%
19.42%
16.51%
35.1%
93.3%
44%
56%
85

5%OTM 2%OTM
6.07%
18.84%
0.88
1.40
0.96
0.08
0.02
0.07
0.29
0.83
0.19%
0.83
0.19%
0.64%
1.02%
18.86%
9.85%
29.3%
90.6%
44%
56%
85

5.49%
16.76%
1.28
2.75
0.92
0.05
0.01
0.05
0.09
0.71
0.12%
0.72
0.12%
0.57%
1.25%
18.38%
8.18%
28.9%
72.1%
38%
62%
85

ATM

2%ITM

5%ITM

4.40%
15.09%
1.57
4.07
0.89
0.02
0.00
0.01
0.07
0.61
0.02%
0.62
0.02%
0.46%
1.15%
17.31%
7.33%
26.7%
59.7%
34%
66%
85

5.22%
13.71%
1.89
5.77
0.83
0.04
0.01
0.04
0.03
0.52
0.08%
0.53
0.08%
0.51%
1.16%
16.59%
7.32%
23.5%
58.7%
33%
67%
85

3.95%
11.25%
2.34
8.64
0.77
0.06
0.02
0.06
0.15
0.40
0.04%
0.40
0.04%
0.38%
0.92%
14.20%
6.46%
17.7%
50.3%
27%
73%
85

BuywriteStrategyinFavorableMarketEnvironment
TheperiodfromFebruary1,1996toFebruary28,2003isasomewhatfavorableperiodforthe
buywrite(relativetotheunderlyingperformance).Thesecondhalfoftheperiodseems
particularlyfavorableforthebuywrite(relativetotheunderlying)sincetheunderlyingexhibits
adownwardtrendandagenerallyhighpositivespreadofimpliedvolatilityoverrealized
volatility(seeExhibit10).Duringthisperiod,theunderlyingexperiencedalowannualized
returnof3.28%atahighstandarddeviationof21.83(volatilitywasparticularlyhighinthe
secondhalfoftheperiodasshowninExhibit4a).Whiletheperiodincludessomestrongrun
ups,theyarenotnearlyasstrongandsustainedasinthesecond(unfavorable)periodorinthe
third(crisis)period.Exhibit9providessummarystatisticsforthebuywriteperformanceinthis
favorablemarketenvironment.
Asexpected,inthisperiod,the2%OTMbuywriteoutperformstheunderlyingindex.Thebuy
writegeneratesalmosttwicethereturn(5.49%versus3.28%)ataboutthreequartersthe
volatility(16.76%versus21.83%).The2%OTMbuywritesoutperformanceinthisperiodis
furtherconfirmedbytheStutzerindex(0.05versus0.06)andLelandsalpha(+0.12%).A
graphicalpresentationoftheperformanceoverthisperiodisprovidedinExhibit10.

Exhibit10:1MonthBuywriteStrategyGrowthof$100,FavorablePeriod

1MonthBuyWriteGrowthof$100
$200
$190
$180
$170
$160
$150
$140
$130
$120
$110

RUTTR

18|P a g e

ATM

2%OTM

5%OTM

Feb03

Aug02

Nov02

May02

Feb02

Aug01

Nov01

May01

Feb01

Aug00

Nov00

May00

Feb00

Aug99

Nov99

May99

Feb99

Aug98

Nov98

May98

Feb98

Aug97

Nov97

May97

Feb97

Aug96

Nov96

May96

Feb96

$100

Exhibit11:1MonthBuywriteStrategySummaryStatistics,UnfavorablePeriod
1MonthCallBuyWrite Russell
Mar1,2003toOct31,2007
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

20.92%
14.08%
0.05
0.09
1.00
1.27
0.18
1.09
1.00
1.00
1.68%
1.70%
6.84%
10.73%
10.8%
147.1%
30%
70%
56

5%OTM 2%OTM
21.86%
12.66%
0.30
0.07
0.95
1.48
0.22
1.31
0.11
0.85
0.25%
0.88
0.22%
1.73%
2.03%
6.39%
9.22%
9.1%
151.5%
25%
75%
56

19.63%
10.52%
0.23
0.59
0.89
1.58
0.25
1.41
0.26
0.66
0.34%
0.69
0.31%
1.55%
1.94%
5.21%
9.47%
7.5%
130.8%
23%
77%
56

ATM

2%ITM

5%ITM

15.79%
7.89%
0.64
1.69
0.81
1.61
0.28
1.42
0.59
0.45
0.34%
0.49
0.30%
1.25%
1.82%
4.74%
7.70%
5.1%
98.2%
21%
79%
56

13.17%
5.90%
0.95
2.65
0.69
1.71
0.36
1.48
0.72
0.28
0.38%
0.32
0.34%
1.05%
1.29%
4.14%
5.82%
4.1%
78.1%
16%
84%
56

9.57%
3.36%
1.45
4.76
0.48
1.94
0.58
1.61
0.87
0.11
0.34%
0.14
0.32%
0.77%
0.84%
3.12%
2.84%
3.1%
53.2%
11%
89%
56

BuywriteStrategyinUnfavorableMarketEnvironment
TheperiodfromMarch1,2003toOctober31,2007isperhapstheepitomeofanunfavorable
environmentfortheperformanceofabuywritestrategy(relativetotheperformanceofthe
underlyingindex)16.TheannualizedreturnfortheRussell2000overthis56monthperiodwas
20.92%.Incomparison,theannualizedreturnintheearlierperiodofFebruary1996toFebruary
2003is3.28%.Inaddition,therunupoccurswithlowvolatilitytheannualizedvolatilityinthe
March2003toOctober2007periodis14.08%comparedwith21.83%fortheearlierperiod.
Thus,focusingontheresultsfromMarch2003toOctober2007allowsustounderstandhow
badlythebuywritestrategyperformedrelativetotheindexinwhatonewouldexpecttobe
oneoftheleastfavorable56monthperiodsinourentiresampleperiod.Interestingly,evenin

16

ThisisparticularlythecaseforATMordeepITMbuywritestrategiesinwhichtheoptionsoftenexpireddeep
ITMduringtheperiodduetothesustainedrallyintheunderlying.

19|P a g e

thisunfavorablemarketenvironment,Exhibit11showsthatthe2%OTMbuywritestrategy
performscrediblywithanannualizedreturnof19.63%almostequalingthereturnoftheindex
(20.92%).Theannualizedvolatilityofthestrategywasonly10.52%comparedtotheRussell's
volatilityof14.08%.Inotherwords,thebuywritestrategyachievedalmostthesamereturnas
theindexatabouttwothirdstheindexvolatility.
Ofcourse,inthisenvironmentonewouldexpectthatanATMorITMbuywritewouldperform
significantlyworsethatanOTMstrategy.Infact,sincethemedianmonthlyreturnoftheRussell
2000(1.70%)overtheperiodisclosetothemoneynessofthe2%OTMcalls,adeeperOTM
strategymaybemoreappropriateforassessinganearworsecasescenario.However,even
theATMor5%ITMbuywritestrategiesoutperformedtheRussell2000onariskadjusted
basis,bysomemeasures.WhiletheabsolutereturnsoftheATMand5%ITMbuywrite
strategies(15.79%and9.57%,respectively)weremuchlowerthantheRussell2000(20.92%),
thebuywritestandarddeviationswerefarlower(7.89%and3.36%,respectively).Thus,the
ATMbuywritegeneratedtwothirdsofthereturnoftheRussell2000atabouthalfthe
volatilityandthe5%ITMbuywritegeneratedhalfthereturnoftheRussell2000atonefifthof
thestandarddeviation.TheriskadjustedoutperformanceisconfirmedbytheStutzerindex
(1.42and1.61,versus1.09fortheunderlying)andLelandsmonthlyalpha(positive0.30%and
0.32%,respectively).

Exhibit12:1MonthBuywriteStrategyGrowthof$100,UnfavorablePeriod

1MonthBuyWriteGrowthof$100
$260
$240
$220
$200
$180
$160
$140
$120

RUTTR

20|P a g e

ATM

2%OTM

5%OTM

Sep07

Jul07

May07

Jan07

Mar07

Nov06

Sep06

Jul06

May06

Mar06

Jan06

Nov05

Jul05

Sep05

May05

Mar05

Jan05

Sep04

Nov04

Jul04

May04

Mar04

Jan04

Nov03

Sep03

Jul03

May03

Mar03

$100

Exhibit13:1MonthBuywriteStrategySummaryStatistics,FinancialCrisisPeriod
1MonthCallBuyWrite Russell
Nov1,2007toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

1.99%
26.78%
0.58
0.03
1.00
0.03
0.01
0.03
1.00
1.00
0.46%
3.01%
20.80%
15.46%
52.0%
123.0%
39%
61%
41

5%OTM 2%OTM
4.03%
24.30%
1.04
0.88
0.96
0.12
0.03
0.11
0.14
0.86
0.16%
0.88
0.16%
0.58%
3.10%
18.81%
10.57%
46.0%
112.0%
34%
66%
41

2.20%
22.07%
1.28
1.94
0.92
0.05
0.01
0.05
0.13
0.75
0.02%
0.77
0.01%
0.39%
2.21%
18.69%
9.68%
42.9%
89.5%
37%
63%
41

ATM

2%ITM

5%ITM

2.36%
20.02%
1.49
3.13
0.87
0.06
0.02
0.06
0.15
0.65
0.03%
0.67
0.03%
0.37%
1.74%
17.84%
10.16%
37.7%
75.0%
37%
63%
41

2.35%
18.60%
1.77
4.72
0.82
0.07
0.02
0.06
0.17
0.57
0.04%
0.59
0.03%
0.34%
1.60%
17.69%
10.01%
34.8%
60.9%
32%
68%
41

3.47%
16.23%
2.14
6.66
0.75
0.15
0.05
0.14
0.13
0.45
0.14%
0.48
0.13%
0.40%
1.04%
16.43%
8.26%
31.3%
52.1%
29%
71%
41

BuywriteStrategyduringtheFinancialCrisis
TheperiodfromNovember1,2007toMarch31,2011coversthefinancialcrisis.Inthisperiod,
theRussell2000exhibitedarapidandverysignificantlossinvaluefollowedbyastrong
recovery.Inaddition,theperiodalsoexhibitedlargespikesinrealizedandimpliedvolatilities.
Exhibit4aprovidesagraphicrepresentationoftheseverityofthespikesinrealizedvolatility.
PerhapsthesinglestatisticthatbestdefinestheimpactofthefinancialcrisisontheRussell
2000isthemaximumdrawdown.Overthe41monthsofthisperiod,theRussell2000
experiencedamaximumdrawdownof52.0%.Thiswassignificantlylargerthanthatofthe
previoustwoperiods(35.1%and10.8%,respectively).Insuchanenvironment,onewould
expecttheextraincomethatcallwritinggeneratesmayhavebenefitedperformanceby
providingacushiontothedrawdowns.However,thisbenefitismitigatedbythereduced
21|P a g e

participationinthemarketrecovery(aswellasthesignificantincreaseexperiencedin
transactionscosts).Exhibits13and14suggestthatthebuywritestrategiesdidprovideasmall
degreeofreturnenhancementovertheperiodwithasignificantreductioninstandard
deviation.The2%OTMbuywritegenerateda2.20%annualizedreturn(1.99%forthe
underlying)atanannualizedstandarddeviationof22.07%(26.78%fortheunderlying).
Therefore,thebuywritegeneratedaslightlyhigherreturnatabout4/5thestandarddeviation.
Similarly,theStutzerindexwassomewhathigherforthebuywrite(0.05versus0.03)and
Lelandsmonthlyalphawaspositive0.01%forthebuywrite.Finally,maximumdrawdownwas
reducedfrom52.0%fortheunderlyingto42.9%forthebuywrite.Inthisperiod,the2%OTM
strategywastheworstperformingofthe1monthbuywritestrategies.Theother
implementationsoutperformedtheunderlyingbyafargreatermargin.

Exhibit14:1MonthBuywriteStrategyGrowthof$100,FinancialCrisisPeriod

1MonthBuyWriteGrowthof$100
$120
$110
$100
$90
$80
$70
$60
$50

RUTTR

22|P a g e

ATM

2%OTM

5%OTM

Mar11

Jan11

Nov10

Sep10

Jul10

May10

Mar10

Jan10

Nov09

Sep09

Jul09

May09

Mar09

Jan09

Nov08

Sep08

Jul08

May08

Mar08

Jan08

Nov07

$40

ReturnAttribution
Inordertobetterunderstandthedriversofreturns,webreakthebuywritereturnsdowninto
theirsourcecomponents17.Themostobvious(andmostsignificant)sourceofreturnsisthe
movementoftheunderlyingRussell2000index.Inadditiontothisobvioussource,weisolate
twootherfactorswhichcontributetothereturns.Aspreviouslymentioned,optionwritingis
subjecttosignificanttransactioncosts.Thesecostswerefoundtohaveasignificantnegative
impactonreturns.Ontheotherhand,optionwritingbenefitsfromthefactthatimplied
volatilitiesaretypicallyhigherthanhistoricalrealizedvolatilities.Thissectionofthepaper
focusesonunderstandingtherelativecontributionofthesetwofactorstotheperformanceof
thestrategy.WebeginbybreakingdownthebuywritestrategyreturnintotheRussell2000
returns,thetransactioncostreturnsandthecallreturns.Wethenfurtherdecomposethecall
returnintothereturnsattherealizedvolatility,thereturnsfromthevolatilityriskpremiumof
thecall,andonceagain,thetransactioncostreturns.Wefirstdecomposethebuywritereturn
intoitscomponents,expressingeachcomponentasapartialreturnonthetotalinvestmentin
thestrategy(longindex,shortcall).
Inthisframework,thebuywritereturnsconsistofthefollowing:
ThereturnsgeneratedbythelongpositionintheunderlyingRussell2000index;

thereturnsthatwouldbegeneratedbysellingthecallatthemidpointofthebidaskspread;

andthe(negative)returnsgeneratedbysellingthecallatthebid,ratherthanthemidpointof
thebidandask;

Thetotalreturnofthebuywriteindexisgivenas:

17

Forthepurposeofreturnattribution,wecalculatemonthlyreturnsfromexpirationtoexpirationratherthan
monthendtomonthend.

23|P a g e

Exhibit15:1MonthBuywriteStrategyReturnAttribution

BuyWriteReturnAttribution
February1996toMarch2011
1.4%
1.2%
1.0%

MonthlyReturn

0.8%
0.6%
0.4%
0.2%
0.0%
0.2%
0.4%
0.6%
5%OTM

2%OTM

ATM

Russell2000Return

CallReturn

2%ITM

5%ITM

Trans.CostReturn

Exhibit15illustratesthisreturndecomposition.WecanseethattheunderlyingRussell2000
indexisbyfarthemaincontributortotheoverallreturnsofthebuywritestrategy,averaging
closeto1%permonth.ItisworthwhiletonotethattheRussell2000returnsvaryslightlyfrom
strategytostrategyduetothedifferentcallpremiumsaffectingthenetinvestmentposition
eachmonth,andthereforethebasisbywhichthereturniscalculated.TheATMandITMone
monthstrategiespresentedinthechartexperienceanaveragebeforetransactioncostloss
fromthecallposition,typicallyaround0.2%permonth.Transactioncostshaveavery
significantcontributiontoreturns.Infact,aftertransactionscosts,thecallpositionsforall
strategiesexceptthe5%OTMgeneratealossfortheportfolio.Thelossduetotransaction
costsisgenerallyclosetothelossgeneratedbythecallpositionbeforetransactionscosts.
Wenowfurtherdecomposethecallreturns.
Thecallreturnsconsistofthefollowing:
ReturnsthatwouldbegeneratedifthecallshadbeensoldattheBlackScholesprice
associatedwiththerealizedvolatilityovertheholdingperiodofthecallposition;18

18

Forthesakeofclarity,weutilizethesamedenominatorintheattributionformulas.Ifastrategycouldbe
devisedthatcapturedonlyasinglecomponentofthereturnssuchassellingthecallsattheexpostrealized
volatility,thereturnbasis(denominator)wouldalsochangecorrespondingly.

24|P a g e

theextrareturnsthataregeneratedbysellingthecallattheBlackScholesimpliedvolatility
ratherthansellingattherealizedvolatility.Wereferredtothisdifferentialearlierasthe
volatilityriskpremiumofthecall.Thisisthedifferencebetweensellingatthemidpointofthe
bidaskspreadandsellingattheBlackScholespriceassociatedwiththerealizedvolatility.On
average,thiswouldrepresentthevolatilityriskpremium;

andthe(negative)returnsgeneratedbysellingthecallatthebid,ratherthanthemidpointof
thebidandask;

Thetotalreturnoftheshortcallpositionisgivenas:

Exhibit16:1MonthBuywriteStrategyShortCallReturnAttribution

CallOptionReturnAttribution
February1996toMarch2011
0.8%
0.6%
0.4%

MonthlyReturn

0.2%
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
5%OTM

2%OTM

MidBid/AskCallatRealizedVol.Return

ATM
Vol.Prem.Return

2%ITM

5%ITM

Trans.CostReturn

Exhibit16providesaclearillustrationoftheattributionofthecallreturns.Itisimmediately
evidentthatwiththeexceptionofthe5%OTMstrategy,thecallswouldgenerateasignificant
lossifsoldattheBlackScholespricesuggestedbytherealizedvolatility.Wecanseeanaverage
25|P a g e

monthlylossfortheseimplementationsofabout0.2%to0.8%attherealizedvolatility,without
evenincludingtransactioncosts.Itisinterestingthatthevolatilityriskpremiumofthecallis
reasonablycloseinmagnitudetothecalllossattherealizedvolatility.Infactwecanseethat
thereturngeneratedbytheriskpremiumofthecallgreatlyreducesthelossesofthecalls.For
example,the2%OTM1monthstrategy'scalllossesarealmostperfectlymatchedbytherisk
premiumgain.Thisreturnattributionanalysisillustratestheimportanceofthevolatilityrisk
premiumtothereturnsonthebuywritestrategy.Whiletheprimarydriverofthereturnsis
clearlytheRussell2000index,Exhibit15suggeststhatthevolatilitypremiumdrivesthe
outperformancewhichweseegeneratedbythebuywritestrategyovertheperiodinstudy.
Exhibit15and16provideasnapshotoftheaveragereturnattributionofthebuywrite
strategy.However,theydonotprovidedetailsonthedynamicnatureofthereturnattribution.
OnewouldexpectthatthecontributionoftheRussell2000tothereturnsofthebuywrite
wouldvarysignificantlyovertimeduetothevolatilityofthereturns.Likewise,onewould
expectthecontributionofthecallpositionpricedattherealizedvolatilitytoshowsimilar,
albeitnegativelycorrelated,movements.

Exhibit17a:1MonthATMBuywriteStrategyReturnAttributionTimeSeries
24MonthRollingReturnAttribution1MonthATM
4.0%

Rolling24MonthAverageMonthlyReturn

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

26|P a g e

Jan11

Aug10

Oct09

Mar10

May09

Jul08

Dec08

Feb08

Apr07

Sep07

Nov06

Jan06

Jun06

Aug05

Oct04

Mar05

May04

Jul03

BuyWriteTotalReturnATM
MidBid/AskCallatRealizedVol.ReturnATM
Trans.CostReturnATM

Dec03

Feb03

Apr02

Sep02

Nov01

Jan01

Jun01

Aug00

Oct99

Mar00

May99

Jul98

Dec98

Feb98

3.0%

Russell2000ReturnATM
Vol.Prem.ReturnATM

Exhibits17a,17band17cprovideagraphicalpresentationofthe24monthrollingaverage
returncontributions.TheExhibitsillustratethesignificantchangesinthecontributionofthe
excessimpliedvolatilityaswellasagradualdecreaseintheimpactoftransactioncosts.Forthe
1month2%OTMbuywrite,theaveragerollingreturnattributedtothevolatilitypremiumhas
graduallydecreasedovertimefromabout1%permonthatthestartoftheperiod.Infact,
duringthefinancialcrisis,theaveragereturnwasrelativelysteadyatabout0.3%permonth,
beforeonceagainturningpositiveattheendoftheperiod.

Exhibit17b:1Month2%OTMBuywriteStrategyReturnAttributionTimeSeries
24MonthRollingReturnAttribution1Month2%OTM
4.0%

Rolling24MonthAverageMonthlyReturn

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

27|P a g e

Jan11

Aug10

Oct09

Mar10

May09

Jul08

Dec08

Feb08

Apr07

Sep07

Nov06

Jan06

Jun06

Aug05

Oct04

Mar05

May04

Jul03

BuyWriteTotalReturn2%OTM
MidBid/AskCallatRealizedVol.Return2%OTM
Trans.CostReturn2%OTM

Dec03

Feb03

Apr02

Sep02

Nov01

Jan01

Jun01

Aug00

Oct99

Mar00

May99

Jul98

Dec98

Feb98

3.0%

Russell2000Return2%OTM
Vol.Prem.Return2%OTM

Exhibit17c:1Month5%OTMBuywriteStrategyReturnAttributionTimeSeries

24MonthRollingReturnAttribution1Month5%OTM
4.0%

Rolling24MonthAverageMonthlyReturn

3.0%

2.0%

1.0%

0.0%

1.0%

2.0%

Jan11

Aug10

Oct09

Mar10

May09

Jul08

Dec08

Feb08

Apr07

Sep07

Nov06

Jan06

Jun06

Aug05

Oct04

Mar05

May04

Jul03

BuyWriteTotalReturn5%OTM
MidBid/AskCallatRealizedVol.Return5%OTM
Trans.CostReturn5%OTM

Dec03

Feb03

Apr02

Sep02

Nov01

Jan01

Jun01

Aug00

Oct99

Mar00

May99

Jul98

Dec98

Feb98

3.0%

Russell2000Return5%OTM
Vol.Prem.Return5%OTM

Conclusion
WeexaminethereturnsonbuywritestrategiesontheRussell2000overtheperiodof
February1996toMarch2011,extendingtheanalysisofKapadiaandSzado[2007]by
approximatelyfiveyears.Overall,ourresultssuggestthatthebuywritestrategycan
outperformtheindexunderstandardperformancemeasures.Thisriskadjusted
outperformancealsoholdsduringtheunfavorablemarketconditionsofMarch2003toOctober
2007,wheretheRussell2000wassteadilytrendingupwards.Theoutperformanceislargely
limitedtowritingonemonthcallswhilethestrategyofwritingtwomonthcallstypically
underperformsboththeonemonthstrategyandtheindex.Toprovideeconomicinsightinto
theperformanceofthestrategy,weinvestigatethecomponentsofthereturns.Althoughthe
maindriverofthereturnistheunderlyingindex,bothtransactioncostsandtheoptionvolatility
riskpremium(definedastheimpliedvolatilitylesstherealizedvolatility)arecriticaltothe
performanceofthestrategy.OurresultsindicatethatiftheoptionwaswrittenattheBlack
Scholespriceassociatedwiththerealizedvolatility,thebuywritestrategywouldunderperform
theindexoveroursampleperiod.Itisclearlyevidentthatthemethodofexecutionofthe
28|P a g e

strategyaswellasthechoiceoftheoptionshasalargeimpactontheperformanceofthe
strategy.Inthislight,wehaveprovidedasomewhatconservativeanalysisofthebuywrite
strategy'sperformance,inthesensethatourimplementationdoesnotallowforanactive
selectionofthemoneynessortimetoexpirationofthecalls.Thereissomeevidenceinthe
literaturethatamoreactiveapproachtocallselectioncanresultinsignificantlyhigherabsolute
andriskadjustedreturns19.

19

See,forexample,RenickerandMallick[2005]andSzadoandSchneeweis[2010].

29|P a g e

Bibliography
Bakshi,Gurdip,andNikunjKapadia,DeltaHedgedGainsandtheNegativeVolatilityRisk
Premium,ReviewofFinancialStudies,16(2)(2003),pp.527566.
CallanAssociatesInc.,Profit/LossanHistoricalEvaluationoftheCBOES&P500BuyWriteIndex
Strategy,CallanAssociatesInc.,Oct,2006.
Feldman,Barry,andDhruvRoy,PassiveOptionsBasedInvestmentStrategies:TheCaseofthe
CBOES&P500BuywriteIndex,IbbotsonAssociates,July28,2004.
Gray,Tim.,BuywriteFunds:ABlastFromtheIndustry'sPast,NewYorkTimes,October15,
2006,MoneyandBusiness/FinancialDeskLateEditionFinal,Section3,Page6,Column1.
Hill,JoanneM.,VenkateshBalasubramanian,Krag(Buzz)Gregory,andIngridTierens,Finding
AlphaviaCoveredCallWriting,"FinancialAnalystsJournal,Sept/Oct2006,pp.2946.
Leland,HayneE.,BeyondMeanVariance:PerformanceMeasurementinaNonSymmetrical
World,FinancialAnalystsJournal,Jan/Feb1999,pp.2735.
Renicker,Ryan,andDevapriyaMallick,EnhancedCallOverwriting,LehmanBrothersGlobal
EquityResearch,Nov17,2005.
Stutzer,Michael,APortfolioPerformanceIndex,FinancialAnalystsJournal,May/June2000,
Vol.56,No.3:5261.
Szado,EdwardandThomasSchneeweis,LooseningYourCollarAlternativeImplementations
ofQQQCollars,JournalofTrading,Spring2010,Vol.5,No.2,pp.3556.
Whaley,RobertE.,ReturnandRiskofCBOEBuywriteMonthlyIndex,TheJournalof
Derivatives,Winter2002,pp.3542.

30|P a g e

Appendix:2MonthBuywriteStrategyPerformance
Thetwomonthbuywritestrategies,ingeneral,underperformtheRussell2000andthe
correspondingonemonthstrategies.Theunderperformanceholdsforboththeentireperiodas
wellasthefirstandlastsubperiods.ItisonlyintheshortersubperiodofMarch2003to
October2007thatthetwomonthstrategiesoutperformtheRussell2000indexandsomeof
thecorrespondingonemonthbuywritestrategiesbothfromanabsolutereturnandrisk
adjustedreturnbasis.Partofthegeneralunderperformancemaybeduetothefactthatthe
timevalueofthetwomonthcallsdecaysslowerthantheshortermaturityonemonthcalls
sincedecaytendstoincreaseasexpirationapproaches.Furthermore,Exhibit3aprovides
evidencethatthetwomonthcallsonaverageexperiencedlowerexcessimpliedvolatility(over
realizedvolatility)andlagerbidaskspreadsthanonemonthcalls(althoughtwomonth
strategiesrollthecallpositionshalfasfrequentlyasonemonthstrategies).Exhibits18through
21providesummarystatisticsfortwomonthbuywritestrategiesfortheentiresampleperiod
andthethreesubperiods.Inaddition,agraphicalpresentationofthetwomonthstrategy
performancerelativetotheunderlyingandtheonemonthbuywriteisprovidedinExhibit22.
Exhibit18:2MonthBuywriteStrategySummaryStatistics,FullPeriod
2MonthCallBuyWrite Russell
Feb1,1996toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

31|P a g e

8.11%
21.06%
0.56
0.81
1.00
0.23
0.05
0.21
1.00
1.00
0.84%
1.68%
20.80%
16.51%
52.9%
226.2%
38%
62%
182

5%OTM 2%OTM
7.21%
17.80%
1.39
3.57
0.94
0.22
0.05
0.29
0.23
0.79
0.00%
0.81
0.01%
0.72%
1.74%
21.18%
10.66%
47.2%
193.7%
33%
67%
182

6.80%
16.30%
1.80
5.76
0.90
0.21
0.05
0.28
0.26
0.70
0.00%
0.72
0.02%
0.67%
1.71%
21.70%
10.23%
44.8%
178.4%
33%
67%
182

ATM

2%ITM

5%ITM

6.43%
15.01%
2.24
8.21
0.86
0.21
0.05
0.27
0.29
0.61
0.00%
0.64
0.02%
0.62%
1.46%
21.70%
8.12%
41.7%
174.0%
31%
69%
182

5.79%
14.06%
2.72
11.36
0.81
0.17
0.05
0.24
0.32
0.54
0.02%
0.57
0.04%
0.56%
1.31%
22.32%
8.14%
41.6%
150.7%
30%
70%
182

5.27%
12.71%
3.37
16.32
0.74
0.15
0.04
0.21
0.34
0.44
0.02%
0.48
0.04%
0.50%
1.03%
22.74%
8.27%
40.2%
139.5%
25%
75%
182

Exhibit19:2MonthBuywriteStrategySummaryStatistics,FavorablePeriod
2MonthCallBuyWrite Russell
Feb1,1996toFeb28,2003
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

32|P a g e

3.28%
21.83%
0.39
0.50
1.00
0.06
0.01
0.06
1.00
1.00
0.47%
0.91%
19.42%
16.51%
35.1%
93.3%
44%
56%
85

5%OTM 2%OTM
2.53%
18.12%
1.07
2.20
0.95
0.12
0.03
0.02
0.24
0.79
0.10%
0.80
0.10%
0.35%
1.29%
19.47%
10.00%
28.4%
59.2%
40%
60%
85

2.48%
16.66%
1.43
3.81
0.93
0.13
0.03
0.04
0.24
0.71
0.12%
0.72
0.12%
0.32%
1.21%
19.47%
8.42%
26.2%
54.4%
41%
59%
85

ATM

2%ITM

5%ITM

2.06%
15.39%
1.87
5.82
0.90
0.17
0.04
0.08
0.27
0.63
0.16%
0.64
0.16%
0.27%
1.21%
19.35%
7.63%
25.2%
54.1%
39%
61%
85

1.77%
14.42%
2.28
8.00
0.86
0.20
0.05
0.12
0.29
0.57
0.19%
0.58
0.19%
0.24%
0.98%
19.24%
6.90%
24.1%
52.7%
38%
62%
85

2.28%
12.95%
2.79
11.02
0.80
0.18
0.05
0.11
0.24
0.47
0.16%
0.49
0.16%
0.26%
0.89%
18.69%
6.08%
21.3%
52.7%
34%
66%
85

Exhibit20:2MonthBuywriteStrategySummaryStatistics,UnfavorablePeriod
2MonthCallBuyWrite Russell
Mar1,2003toOct31,2007
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

33|P a g e

20.92%
14.08%
0.05
0.09
1.00
1.27
0.18
1.09
1.00
1.00
1.68%
1.70%
6.84%
10.73%
10.8%
147.1%
30%
70%
56

5%OTM 2%OTM
19.68%
10.64%
0.38
0.21
0.92
1.56
0.24
1.44
0.27
0.69
0.30%
0.72
0.28%
1.55%
1.88%
5.35%
8.19%
7.4%
131.2%
21%
79%
56

18.24%
8.68%
0.57
1.20
0.84
1.75
0.29
1.58
0.39
0.51
0.43%
0.55
0.40%
1.44%
1.72%
5.18%
7.19%
5.2%
118.6%
18%
82%
56

ATM

2%ITM

5%ITM

17.20%
7.30%
0.60
2.10
0.75
1.94
0.37
1.72
0.43
0.39
0.53%
0.43
0.50%
1.35%
1.57%
4.57%
6.45%
4.6%
109.7%
16%
84%
56

16.01%
5.91%
0.45
3.63
0.65
2.19
0.48
1.93
0.49
0.27
0.61%
0.31
0.57%
1.26%
1.33%
4.07%
6.47%
4.1%
100.0%
14%
86%
56

12.78%
4.31%
0.57
4.05
0.50
2.26
0.65
1.97
0.67
0.15
0.54%
0.18
0.50%
1.02%
0.98%
3.48%
4.20%
3.5%
75.3%
7%
93%
56

Exhibit21:2MonthBuywriteStrategySummaryStatistics,FinancialCrisis
2MonthCallBuyWrite Russell
Nov1,2007toMar31,2011
2000TR
AnnualizedReturn
AnnualizedStandardDeviation
Skewness
ExcessKurtosis
CorrelationwithRUT
SharpeRatio
TreynorRatio
StutzerIndex
InformationRatiowithRUT
CAPMBeta
Jensen'sMonthlyAlpha
Leland'sBeta
Leland'sMonthlyAlpha
MeanMonthlyReturn
MedianMonthlyReturn
MinimumMonthlyReturn
MaximumMonthlyReturn
MaximumDrawdown
MaximumRunUp
%DownMonths
%UpMonths
NumberofMonths

1.99%
26.78%
0.58
0.03
1.00
0.03
0.01
0.03
1.00
1.00
0.46%
3.01%
20.80%
15.46%
52.0%
123.0%
39%
61%
41

5%OTM 2%OTM
1.18%
23.90%
1.38
2.33
0.92
0.00
0.00
0.13
0.19
0.82
0.06%
0.84
0.06%
0.35%
2.33%
21.18%
10.66%
47.2%
97.3%
34%
66%
41

1.25%
22.40%
1.66
3.66
0.89
0.01
0.00
0.12
0.20
0.74
0.05%
0.76
0.05%
0.32%
2.36%
21.70%
10.23%
44.8%
89.1%
37%
63%
41

ATM

2%ITM

5%ITM

1.78%
20.87%
1.98
5.11
0.86
0.03
0.01
0.14
0.17
0.66
0.00%
0.69
0.01%
0.34%
2.34%
21.70%
8.12%
41.7%
81.4%
37%
63%
41

1.05%
19.95%
2.30
6.86
0.81
0.00
0.00
0.10
0.23
0.60
0.05%
0.63
0.06%
0.26%
1.86%
22.32%
8.14%
41.6%
70.9%
37%
63%
41

1.70%
18.64%
2.77
9.70
0.74
0.03
0.01
0.13
0.20
0.51
0.01%
0.54
0.01%
0.30%
1.47%
22.74%
8.27%
40.2%
62.7%
29%
71%
41

Exhibit22:2MonthBuywriteStrategyGrowthof$100,FullPeriod

2%OTMBuyWriteGrowthof$100
$400
$350
$300
$250
$200
$150
$100
$50

RUTTR

34|P a g e

2Month2%OTM

Feb11

Aug10

Feb10

Feb09

Aug09

Feb08

Aug08

Feb07

Aug07

Feb06

Aug06

Feb05

Aug05

Feb04

1Month2%OTM

Aug04

Feb03

Aug03

Feb02

Aug02

Aug01

Feb01

Feb00

Aug00

Aug99

Feb99

Feb98

Aug98

Feb97

Aug97

Feb96

Aug96

$0