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THE S&P 500 STOCK COVERED CALL INDEX: WHY, WHEN AND HOW IT WORKS Introduction Yield generation has been a popular investment theme in recent years. The covered call strategy is a common derivatives strategy
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THE S&P 500 STOCK COVERED CALL INDEX: WHY, WHEN AND HOW IT WORKS Introduction Yield generation has been a popular investment theme in recent years. The covered call strategy is a common derivatives strategy used by traditional long-only asset managers seeking yield. Selling calls on securities that have limited upside potential allows investors to convert the upside exposure of securities into current yield, reducing the reliance on rising prices to generate returns. Covered call strategies generally outperform an outright long allocation except during a significant rally. Contributor: Berlinda Liu, CFA Director Index Research & Design Single-stock and index-based covered call strategies have been explored in the industry and the academic world. However, little reasearch or practice has tackled overwriting stock options on an equity basket. In this paper, we investigate the S&P 500 Stock Covered Call Index, which simulates the return of a hypothetical portfolio that writes monthly out-of-themoney (OTM) calls on individual stocks in the S&P 500. The strike of each call option is determined by the implied volatility of the underlying stock. We also discuss its performance and income distribution feature. Covered Call Strategy A covered call strategy is an income-generating strategy whereby an investor shorts a call option and simultaneously longs the underlying security. The purpose of this transaction is to collect the premium paid by the option buyer. If the stock price does not rise above the strike price of the call, the covered call strategy will outperform the equivalent long-only position. The long position in the underlying security is said to provide the cover as the shares can be delivered to the buyer of the call option if the buyer decides to exercise the option. This relatively straightforward strategy sells one type of potential gain (unlimited capital gain) in exchange for another type (capital gain up to the strike price plus option premium). In essence, investors forego the chance of unlimited capital gain for what they believe to be a higher probability of increased total return. Exhibit 1 shows the results of one implementation of the covered call strategy. If we went long Apple (AAPL) stock on May 29, 2013 and shorted the June strike call, we would have paid USD for the stock and collected USD 9.40 from the option. The net cost of this transaction would have been USD If the stock stayed flat at the expiry, the net return would have been 9.4/435.55=2.16%. If the stock rose above the USD 450 strike, however, the net return would have been capped at ( )/435.55=3.32%. In other words, the market participant who Want more? Sign up to receive complimentary updates on a broad range of index-related topics and events brought to you by S&P Dow Jones Indices. implemented the strategy would not benefit from the stock price increase above the option strike. If the stock declined, however, the premium collected from the call option would provide a cushion to the downside risk. The breakeven point of the strategy would be USD Exhibit 1: Illustration of a Covered Call Strategy Long Stock Short Call Net w/o Premium Net w/ Premium Payoute Stock Price at Expiry Transaction Date: 5/29/2013 Stock: AAPL Stock Price: Option Expiration: 6/13/2013 Strike: 450 Bid/Ask: 9.40/9.65 Source: S&P Dow Jones Indices. Data as of May 29, Charts are provided for illustrative purposes. Looking at this example, we notice some interesting properties of the covered call strategy if the call strike is greater than the initial stock price: If the stock price stays flat or range bound, the call option will not be exercised at the expiry. The strategy generates income from the call option. If the stock price declines by the option expiry, the call option will not be exercised. The strategy is subject to losses from the long stock position, but the option premium will mitigate the loss. If the stock price rises above the call strike by the expiry, the call option will be exercised. The strategy will lose any price appreciation above the call strike and the total return is capped. Finally, a capped upside and a cushioned downside narrow the distribution of potential returns compared to a long-only position. So lower volatility is always observed in a covered call portfolio relative to an equivalent long-only position. Indexing a Stock Covered Call Strategy The CBOE S&P 500 BuyWrite Index (BXM) is a widely followed covered call strategy benchmark. It consists of going long the S&P 500 index while shorting at-the-money (ATM) call options on the S&P 500. Academics and investment consultants have studied the CBOE S&P 500 BuyWrite Index in terms of return and risk characteristics. A report from Asset Consulting Group [2012] states that from June 20, 1988 to December 31, 2011, the CBOE S&P 500 BuyWrite Index had an annualized return of 9.1% with about two-thirds the volatility of the S&P 500. The gross monthly premium collected by the CBOE S&P 500 BuyWrite Index was 1.8%. Unlike the CBOE S&P 500 BuyWrite Index, the S&P 500 Stock Covered Call Index (Bloomberg: SPXCC) writes monthly OTM calls on the individual constituents of the S&P 500. Due to the diversification benefits of an index basket, the volatility of an index is lower than the weighted average of the volatilities of its constituents. Since selling calls essentially means selling the implied volatility of the underlying security, it would appear that the yield derived from selling stock calls tends to be higher than that derived from selling index calls. 2 To implement this stock covered call strategy, we consider the following variables: Strike. We use the implied volatility of each individual stock to determine the strike of the call options. Writing calls at a strike close to the spot price usually collects more premium since it gives up more upside potential. However, it also increases the chance that the call option will be exercised. Hill, Balasubramanian, Gregory and Tierens [2006] examined the historical return and risk characteristics of a variety of short-term S&P 500 covered call strategies, and recommended OTM strategies over their ATM counterparts. Their empirical study showed that OTM strategies exhibited a better trade-off between the reduction in the expected exercise cost and the reduction in the call premium associated with moving from ATM to OTM. In particular, they recommended strategies that were at least 2% OTM or had a 30% or less probability of exercise. In our case, since volatilities vary among the index constituents, we use the implied volatility of each individual stock to determine the strike. After the close of the trading day prior to the index roll day, we calculate the implied volatility (vol) of each constituent. The strike of the new call option, K, is 0.75 * vol above the opening price of that stock on the roll day. If K falls between two option strikes, we choose the call option that is immediately below K as long as the option is OTM or ATM. Assuming normal distribution, the probability of being exercised is approximately 23%. Time to expiration. Just like the benchmark index (the CBOE S&P 500 BuyWrite Index), we use one-month call options to optimize premium income. Most of the decay in a call option s time value, a major component of its total value, tends to occur in the final month. Therefore, writing one-month call options is generally more likely to capture this time value. Writing longer-dated options offers a moderate increase in premiums, but may heighten the risk that the underlying stocks will rise above their strike price by expiration. Deutsche Bank Global Market Research [2011] showed that three-month NIKKEI 225 calls were called more than half of the time and the call-away ratio of one-month options was just 18%. Delta adjustment. We usually write 100% on all option-eligible stocks to maximize income and increase portfolio diversification. However, if the call has a delta greater than 0.3, we reduce the number of shares of calls to be written in order to reduce the possible exercise cost. In this case, the delta adjusted number of shares is number of shares of the underlying stock * 0.25 / delta. Monthly roll. The index unwinds its current call position and sells new calls on the third Friday of each month. For a call option to be written, stocks must satisfy the following constraints: 1) the stock price must be greater than or equal to USD 10; 2) the roll spread, defined as the bid of the new option less the ask of the old option, must be greater than or equal to 15 cents. If these constraints are met at noon, the corresponding covered call is rolled at noon. Otherwise, if the constraints are met at the close of market, the corresponding covered call is rolled at close. If the constraints are not met at either time, no call is written on that stock. Corporate actions. If the number of shares of a specific stock increases due to corporate actions between two roll days, the number of call options remains as-is. If the number of shares of a stock decreases due to corporate actions between two roll days, however, a proportional number of call options is bought back on the day prior to the corporate action effective date, thereby avoiding a situation in which a call position is uncovered. Option type. To simplify the model, we assume that all stock options are European options. Early exercise is not allowed. Stock Covered Call Strategy Performance Since the S&P 500 Stock Covered Call Index writes OTM calls, it tends to maintain more upside potential and higher volatility than the CBOE S&P 500 BuyWrite Index. This trend is observed when we examine the historical performance of both indices. Exhibit 2 shows that the S&P 500 Stock Covered Call Index usually falls between the long-only S&P 500 and the CBOE S&P 500 BuyWrite Index, in terms of return, volatility and maximum drawdown. The statistics in the table are calculated as of May 31, Since the equity market has been showing strong returns this year, the two covered call indices have both underperformed. However, over a longer time horizon the 3 underperformance is less pronounced than during more recent time periods. Both covered call indices have noticeably lower risk statistics. Exhibit 2: Performance, Volatility and Maximum Drawdown of the S&P 500, CBOE S&P 500 BuyWrite Index and S&P 500 Stock Covered Call Index (May 31, 2013) S&P 500 CBOE S&P 500 BuyWrite Index S&P 500 Stock Covered Call Index Annualized Return (%) 1 Year Years Years Years Years Annualized Volatility (%) 1 Year Years Years Years Years Maximum Drawdown (%) Exhibits 3a and 3b show the year-by-year performance of the equity market and the two covered call indices. When the equity market had a two-digit rally (2006, 2009, 2010, 2012, Jan.-May 2013), the S&P 500 Stock Covered Call Index captured more upside than the CBOE S&P 500 BuyWrite Index. Its returns during these years more closely reflected growth in the equity market. In a strong bear market (2008), both covered call indices outperformed, and the ATM options used in the CBOE S&P 500 BuyWrite Index offered more downside cushion than the OTM options used in the S&P 500 Stock Covered Call Index. Since the S&P 500 Stock Covered Call Index uses OTM calls, its historical volatility consistently fell between that of the equity market and the CBOE S&P 500 BuyWrite Index. 4 Exhibit 3a: Performance and Volatility of the S&P 500, CBOE S&P 500 BuyWrite Index and S&P 500 Stock Covered Call Index Annual Return (%) S&P 500 CBOE S&P 500 BuyWrite Index S&P 500 Stock Covered Call Index 2004* Jan-May Annual Volatility (%) 2004* Jan-May *2004 statistics are calculated based on data from January 16, 2004 to December 31, Exhibit 3b: Annual Returns of the S&P 500, CBOE S&P 500 BuyWrite Index and S&P 500 Stock Covered Call Index 40% 20% 0% -20% -40% -60% Jan-May 2013 S&P 500 CBOE S&P 500 BuyWrite Index S&P 500 Stock Covered Call Index *2004 statistics are calculated based on data from January 16, 2004 to December 31, Exhibits 4a and 4b shows the cumulative return of the equity market and the two covered call indices as well as their behaviour during different stages of the business cycle. In a range bound market (January October 2004), the two covered call indices both outperformed the equity market. In these years, the index 5 call option showed the diversification benefit over the stock call options in terms of lower exercise cost, which explains why SPXCC returned less than CBOE S&P 500 BuyWrite Index. When the market dropped 43% (April 2008 February 2009), both covered call strategies offered downside cushion to reduce the loss. When the equity market rose 55% (March 2009 December 2009), however, SPXCC captured more upside participation than CBOE S&P 500 BuyWrite Index. It realized 94% of the market growth while CBOE S&P 500 BuyWrite Index captured only 72%. Exhibit 4c shows the cumulative return difference between the S&P 500 Stock Covered Call Index and the S&P 500, defined as the cumulative return of the S&P 500 Stock Covered Call Index minus the cumulative return of the S&P 500 Index, since Jan. 16, The S&P 500 Stock Covered Call Index clearly outperformed the S&P 500 between 2008 and 2009 when the market dropped drastically. Exhibit 4a: Historical Performance During Different Stages of the Business Cycle Range Bound Market Bear Market Bull Market 60 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 S&P 500 Total Return Index CBOE S&P 500 BuyWrite Index S&P 500 Stock Covered Call Index Exhibit 4b: Historical Performance During Different Stages of the Business Cycle Stage of CBOE S&P 500 BuyWrite S&P 500 Stock Covered Call Period S&P 500 Return (%) Business Cycle Index (%) Index Return (%) Range Bound 1/16/ /31/ Bear 4/1/2008 2/28/ Bull 3/1/ /31/ Exhibit 4c: Cumulative Return Difference Between the S&P 500 Stock Covered Call Index and S&P 500 Cumulative Return S&P 500 Cumulative Difference Return Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan Cumulative Return Difference S&P 500 Total Return Index Income Distribution of a Stock Covered Call Strategy The return of a stock covered call strategy can be broken down into the following components: The price return of the underlying stocks The dividend received from the underlying stocks The gross option premium received from writing new calls The total cost, including exercise cost of the expiring options and trading cost. As the index does not let options expire, the exercise cost is associated with the buyback prices of the expiring options. The trading cost is the cost associated with the bid/ask spread of the call options the index is evaluated at mid prices on non-roll days, but sells new options at bid and buys back expiring options at ask. This return slippage on roll days amounts to approximately 150 bps per year and is relatively stable. The exercise cost dominates the total cost and may vary on a monthly basis. Compared with the S&P 500 Total Return index, which also includes the price return and the dividend return, the difference in performance resulting from a covered call strategy can be attributed to the call premium and the exercise cost. If the index distributes income on a monthly basis, the total income distribution is the gross option premium received from writing new calls plus the dividend received from the underlying stocks in the past month minus the total cost. We also define net option premium as the gross option premium net of the total cost. Total Cost = Exercise Cost + Trading Cost Net Option Premium = Gross Option Premium Total Cost Income Distribution = Dividend + Net Option Premium Income Distribution = Dividend + Gross Option Premium Total Cost Exhibit 5 shows the year-by-year yield generated by the S&P 500 Stock Covered Call Index. The gross option premium received from writing new calls generated more yield than the dividend received from the underlying stocks. Unlike the relatively stable dividend yield, gross option premium fluctuated with the market condition. It peaked in 2008, 2009 and 2011 when the market was more volatile and options were rich, and fell when the market rallied and options became cheaper. The exercise cost, however, also peaked in 2008, 2009 and 2011, because the expiring option prices rose with the heightened volatility. The net option premium was the highest in 2008 (4.65%) and lowest in January-May 2013 (-6.18%). Our backtest shows that the S&P 500 Stock Covered Call Index had no income to distribute in 2012 and 2013, if the income was distributed annually. In other years, the income distribution varied from 0.41% to 6.85%. 7 Exhibit 5: S&P 500 Stock Covered Call Year-by-Year Income Distribution *2004 statistics are calculated based on data from January 16, 2004 to December 31, Exhibits 6a and 6b show the month-by-month yield generated by the S&P 500 Stock Covered Call Index. During the 113 months included in the backtest, the index generated positive income in 59 months. Although the gross option premium yield peaked in October 2008 (2.93%), the net option premium yield and the income distribution reached their maximum amounts in February 2009 at 1.57% and 1.92%, respectively. Although Exhibit 5 showed that the yearly income distribution in 2012 was zero, our backtest shows that, if income was distributed monthly, there would have been positive income in April, May, June, July, October and November of Due to the market rally and high exercise costs, the S&P 500 Stock Covered Call Index had no positive net income to distribute in the first five months of Exhibit 6c lists the number of months each year when the S&P 500 Stock Covered Call Index distributed positive income. Exhibit 6d shows the average monthly income distribution in different business cycles. The index was able to distribute more income when the market was down due to the higher option premium collected from writing the calls. Exhibit 6a: S&P 500 Stock Covered Call Month-by-Month Income Distribution 4% 3% 3% 2% 2% 1% 1% 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% performance is no guarantee of future results.. This chart may reflect hypothetical historical performance. Please see the Performance Disclosure at the end Jan- May 2013 S&P 500 Dividend Yield 1.61% 1.85% 1.91% 1.93% 2.20% 2.50% 2.02% 2.07% 2.33% 0.90% Gross Option Premium Yield 7.65% 6.88% 8.31% 10.62% 18.69% 15.76% 11.62% 12.19% 9.76% 3.80% Annual Income Distribution 1.26% 0.41% 0.92% 1.17% 6.85% 3.53% 0.75% 2.04% 0.00% 0.00% S&P 500 Dividend Yield Gross Option Premium Yield Income Distribution 0% Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 8 Exhibit 6b: S&P 500 Stock Covered Call Month-by-Month Income Distribution S&P 500 Dividend Yield (%) Gross Option Premium Yield (%) S&P 500 Stock Covered Call Index Income Distribution (%) Mean Median Min Max Exhibit 6c: Number of Positive Income Distribution Months Jan-May Exhibit 6d: Average Income Distribution in Different Stages of the Business Cycle S&P 500 Monthly Price Return Less than 0% Between 0% and 2% Greater than 2% Average Dividend Yield (%) Average Gross Option Premium Yield (%) Average Income Distribution Yield (%) Conclusions Covered call strategies are total return strategies in that the investor forfeits some upside potential in exchange for a call premium paid up-front. They have generally outperformed a long-only equity position in range-bound, bear and moderate bull markets, but have underperformed in strong bull markets. With a capped upside and cushioned downside exposure, covered call strategies have generally mitigated surprises on both sides of the return spectrum and delivered a total return with a lower volatility. The S&P 500 Stock Covered Call Index is implemented on a dynamic basis. One-month calls are written on the individual constituents of the equity portfolio and at strike levels determined by the implied volatility of t
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