More on PUT Returns

Given the surprising interest in put-write strategies and the CBOE PutWrite Index (PUT), I have spent some additional time with the PUT data to see what sort of secrets I might be able to uncover.

I must confess that the more I dig, the more I am intrigued by this index put-write approach. Since there has been considerable discussion about the differences in return between the PUT and the closely related CBOE BuyWrite (BXM) Index, I will start by showing a table that has a year-by-year comparison of the PUT and the BXM. Just for fun I threw in the average VIX for each year, the change in the average VIX from year to year, the VIX range for the year and a ratio of that range divided by the average VIX. While none of these additional data points provides a smoking gun, each offers up a piece of the overall performance puzzle.

The second graphic is a simple matrix of monthly returns for the PUT since 1986. Not surprisingly, the two worst monthly returns were during the volatility peaks in October 1987 and October 2008. In a related note, several of the most profitable months for the PUT came just after high volatility events.

[Source: CBOE, VIX and More]

For those looking to dig deeper into this issue, consider that put-write absolute and relative returns are largely a function of implied volatility, the trending characteristics of the SPX and interest rates. Note also that that upper chart only goes back to June 1^st, 1988 because that is when Standard & Poor’s began reporting daily dividends for the S&P 500 Total Return Index.

Graphical Comparison of Performance of PutWrite and BuyWrite Indices

I was pleased to see the strong response generated by Friday’s The Often Overlooked Put Writing Strategy, particularly in some of the comments at Seeking Alpha, where the post was republished. A number of questions came up regarding the reasons why two strategies that are synthetically equivalent (i.e. share the same profit and loss graph), would have different performance characteristics. I cited the main reason for the performance delta as the skew that results from a tendency to price puts higher than calls, particularly during times of extreme market stress, when demand for puts often exceeds the demand for calls.

I am not sure that I can prove beyond a reasonable doubt the skew hypothesis in this space, but I did assemble two performance graphs that might help to inform any further discussion. Using the CBOE PutWrite Index (PUT) and the CBOE BuyWrite Index (BXM) as my source data, I have plotted the two indices from their 1988 inception (above) and from 2002 (below), when the indices begin to substantially diverge.

From the two graphs, I find it interesting that the put-write strategy begins to generate separation from the buy-write strategy during the 2002-07 bull market. As volatility increases during 2007, the put-write strategy continues to widen the gap, with the recent bear market having very little impact on the performance differential between the strategies.

Those who have any thoughts on the reasons behind the performance differential during different market cycles, please feel free to chime in.

[source: CBOE, VIX and More]

The Often Overlooked Put Writing Strategy

Shame on me for going a year and a half without mentioning the CBOE S&P 500 PutWrite Index (PUT), a recipient of the Most Innovative Benchmark Index award at last year’s Super Bowl of Indexing Conference.

Given all the market volatility for the past three months or so, I suspect that a put writing strategy is probably not top of mind for most investors at the moment. In fact, a put write strategy like one tracked by the PutWrite Index will generally outperform the S&P 500 index in a down trending market and significantly outperform the S&P 500 index in a sideways market. Much like a covered call strategy, however, a put write approach will not match the gains of the underlying index in a strong bull market rally.

The CBOE describes the PutWrite Index methodology as follows:

“The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.”

Additional information about the PutWrite Index is available at the CBOE PutWrite Index splash page.
I mention put write strategies for four reasons:

1. If we continue in a non-trending market, as I expect we will, this is an excellent investment approach
2. Ennis Knupp just published a superb analysis of the PutWrite Index: Evaluating the Performance Characteristics of the CBOE PutWrite Index
3. Put write strategies have historically outperformed the more widely utilized buy write strategies
4. Properly implemented, a put write strategy is not as risky as most investors expect
   

At a minimum, readers should check out the Ennis Knupp paper and get a better sense of the essence of put write strategies. Those who expect the markets to do anything other than rally significantly might also want to start implementing that strategy on their own.

Note that while there are currently no ETFs that utilize a put write strategy, it is a volatility strategy that is practiced by hedge funds.

The Value of Selling Covered Calls

One subject that gets less attention than it deserves is the value investors can extract from selling covered calls. To be fair, a covered call strategy sacrifices what can sometimes be considerable upside in exchange for a fixed return, but this can be a highly effective strategy in a range-bound market.

The chart below is a weekly chart that shows the CBOE S&P 500 Buy-Write Index (BXM), which is designed to replicate a buy-write or covered call strategy for the S&P 500 Index. Note that during the recent bull market, a buy-write strategy resulted in roughly the same returns as owing the SPX, but with less volatility.

[source: StockCharts]

More importantly, over the course of the last year, a buy-write strategy has significantly outperformed the SPX. The details can be seen in the next chart, where a relatively new ETF, the PowerShares S&P 500 BuyWrite Portfolio (PBP) has lost value at less than half of the rate of the losses in the SPX.

In sideways markets, in down markets, and even in up markets, a buy-write or covered call approach like that of the PBP (or first cousins BEP and MCN) can be an excellent way to increase returns and reduce risk.

[source: BigCharts]

One Approach for Volatile Sideways Markets

About two months ago, I talked about three different buy-write products (two closed-end funds and an exchange-traded note or ETN) which are designed to mimic a strategy of writing covered calls, such as is tracked by the CBOE S&P 500 Buy-Write Index (BXM.)

I was being a little cheeky when I suggested that this index might be useful as a market timing tool. Instead, I figured that the best application of a buy-write strategy would likely be as a cash equivalent of sorts, particularly for those who were looking for a place to park their money somewhere that it could earn a reasonable return in a volatile sideways market, yet participate in any unexpected upward moves.

I think we may be in just that market environment right now.

If you are worried about the RUT falling through its 200 day SMA today and most of the other major indices penetrating their 50 day SMAs, then perhaps you should take a long look at the BEP, MCN and BWV. I am slightly partial to the BWV, because, as an ETN, it will not have (taxable) distributions. There has been very little volume in BWV in the two months it has traded, but with a typical bid-ask spread of 0.10, it is competitive with the more liquid BEP and MCN at least on a small scale.

BuyWrite Index as a Timing Tool?

Adam at Daily Options Report has recently been talking about the CBOE S&P 500 BuyWrite Index (BXM) and related products in considerable detail – enough for me to finally take a look at it myself. Between the information on the CBOE site linked above, Adam’s comments and the insights of ETF-friendly blogger ‘Random’ Roger Nusbaum, you can find out just about anything you might wish to know about the BXM and products that utilized covered call strategies. Well, almost anything.

I got to wondering whether or not the BXM might be useful as a timing tool. After spending a little time at StockCharts.com, I put together several ratio charts that compare the SPX to the BXM. In a weekly ratio chart, appended below, I noted that for the last several years when the SPX to BXM ratio approaches 1.80 (or generally makes any 6-12 month high) and rolls over, this has usually provided some advance warning of a significant correction in the SPX over the next two to three months. What particularly caught my attention in the current chart is very high 1.836 moving average reading that appears to be just beginning to roll over.

This ratio is something worth watching; and the BXM and related products (BEP, MCN, and the newly minted ETN, BWV) are another way to think about harvesting volatility in what could be turning into a toppy market.