Enhanced Call Overwriting*
Systematically overwriting the S&P 500 with 1-month at-the-money calls, rebalanced on a monthly basis at expiration, outperformed the S&P 500 Index during our sample period (1996 – 2005). This “base case” overwriting strategy also generated superior risk-adjusted returns versus the index.
Overwriting portfolios with out-of-the-money calls tends to outperform at-the-money overwriting during market rallies, but provides less protection during market downturns. However, out-of-the money overwriting also results in relatively higher return variability and inferior risk-adjusted performance.
During the sample period, overwriting the S&P 500 with short-dated options, rebalanced more frequently, outperformed overwriting with longer-dated options, rebalanced less frequently. We discuss possible explanations for these performance differences.
We find that going long the market during periods of heightened short-term anxiety, inferred from the presence of relatively high S&P 500 1-month at-the-money implied volatility, has, on average, been a winning strategy. To a slightly lesser extent, having relatively less exposure to the market during periods of complacency – or relatively low implied market implied volatility – was also beneficial.
We create an “enhanced” overwriting strategy – whereby investors systematically overwrite the S&P 500 or Nasdaq 100 with disproportionately fewer (more) calls against the indices when risk expectations are relatively high (low).
Our enhanced overwriting portfolios handily outperformed the base case overwrite portfolios and the respective underlying indices, on an absolute and risk-adjusted basis. For example, the average annual return for the S&P 500 enhanced overwriting portfolio from 1997 – 2005 was 7.9%, versus 6.6% for the base case overwrite portfolio and 5.5% for the S&P 500 Index.
Overwriting with fewer calls when implied volatility is rich, and more calls when implied volatility is cheap, could improve the absolute and risk-adjusted performance of index-oriented overwriting portfolios.
This goes against the conventional tendency for investors to sell calls against their positions when implied volatility is high.
*Renicker, Ryan and Devapriya Mallick., “Enhanced Call Overwriting.”, Lehman,Brothers Global Equity Research Nov 17, 2005.