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Wednesday, March 6, 2013

Covered Call vs Buy and Hold. Performance comparison.

Some time ago, I wrote an article about a simple strategy that beats most traders. The article was about the fact that with the historical upside bias of the markets, plus the fact that 90% of traders lose money and 75% of money managers can't beat the S&P500, then by simply going long shares of SPY you would be better off than the majority of traders (including the so called professionals). You would basically track the performance of the S&P500. You would also receive a dividend from owning the shares and you wouldn't pay the whole spectrum of ridiculous fees that most funds impose for their under-performance (Early Redemption Fees, Deferred Sales Charges, Performance Fees, Maintenance fees etc).

That simple strategy, although extremely boring and not exempt from volatile periods, would put most big funds in the industry out of work. By the end of the article I mentioned the idea of using 10% of the Fund to sell Out of the Money Calls in order to enhance the returns a little bit more, and then not only be ahead of most traders but also beat the S&P500. However, I didn't have the hard evidence to support this last claim.

Can a totally passive, mechanical Covered Call strategy outperform the S&P500 returns over a long period of time?

The short answer is YES.

The BXM Index, traded in the US markets, is basically a simulation of a Covered Call strategy where the investor holds an S&P 500 stock index portfolio, and "writes" (or sells) the front month, near-term S&P 500 Index (SPXSM) "covered" call option, on the third Friday of each month.

The index was introduced in 2002 and a back-test from 1988 to 2003 reflects the following results:

Taken from the book Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options 

Obviously the strategy under performs in those years where the market rallies considerably. But it outperforms the rest of the years and overall during the entire period.

Another study by Allan Associates from June 1988 to August 2006 concluded that "...the compound annual return of the BXM was 11.77% compared to 11.67% for the S&P 500, and BXM returns were generated with a standard deviation of 9.29%, two-thirds of the 13.89% volatility of the S&P 500."

Meaning that the strategy outperforms a simple Buy/Hold of SPX and it does it with a smoother equity curve.

There is a similar index in the Canadian markets (MCWX: Montreal Exchange Covered Call Writers Index) that also simulates a permanent Covered Call strategy that holds shares of an ETF, the Standard & Poor’s Toronto Stock Exchange 60 (TSE60), and sells a Call option that is the closest to the money (rather than the first out of the money). So, if the closest strike at options expiration is the first in the money strike, then Calls of that strike are sold. The Call is simulated to be sold the Monday right after expiration Friday (so the strategy is slightly different from the one used by the BXM American index).

Taken from the book Create Your Own Hedge Fund: Increase Profits and Reduce Risks with ETFs and Options

Once again the results show an out performance over the simple buy and hold of the ETF.
From 1993 to 2003 the MCWX index shows a Compounded 181.37% return versus 107.11% for the TSE60.

So, the evidence suggests, that a simple mechanical Covered Call strategy on a Benchmark index tends to outperform over the long term. The Covered Call strategy will under perform the months  when the market rallies beyond the Short Call strike price. But it will reduce your losses during market sell offs and it will generate profits during sideways markets. As the table for the MCWX Index shows, some years the strategy will underperform but in the long run not only did it beat the markets benchmark but it also did it with a less volatile portfolio (smaller drawdowns).

Really interesting in my opinion, because, when you think about it....why would anybody pay for a so called "proffesional" to manage their money?

I hope you enjoyed this article.

For more information visit:

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  1. Hi, what do you think about running this strategy with weekly options, to write covered calls more frequently and with a higher intrinsic value?

  2. Overall I think selling weeklies is not a good long term business. Too much Gamma risk. Small premiums impacted by commissions more drastically etc. It would take a serious study but my first impression is always to avoid selling weeklies.