What are the advantages and risks of such a strategy?

Overwriting can boost returns in the event of a price drop or a modest rally, and the call sale lowers overall portfolio volatility. The premium reduces the effective cost of the stock or index and the investor will continue to collect dividends (if any) as long as the underlying is held. The premium received by the investor is payment to compensate for the upside potential he forgoes. Put in other words, this is a compensation for the obligation to sell the underlying at the strike price. Indeed, investors are at risk of losing the underlying security should it rise above the strike price at expiration and the owner of the call decides to exercise. Investors who cannot or do not want to sell their holdings for some reason should not pursue a Buy Write strategy.

What should an investor look for when considering a Buy Write strategy?

First, investors active in listed options markets select an index or a stock that is eligible to a Buy Write strategy. They have a neutral or moderately bullish view relative the stock or index, or perhaps they want to take advantage of a corporate action or special situation. Second, they assess the underlying options using two criteria: how rich or cheap is the implied volatility and market liquidity. One must also pick the best strike and maturity.

What is the DJ Stoxx Buy Write Index?

In the past 4 to 5 years, some derivatives exchanges have launched strategy indices that systematically roll Buy Write strategies. Most of the time, the strike is reset at 100% of the index level on a monthly basis. More recently, Stoxx launched the Dow Jones EURO STOXX 50 Buy Write with a 105% strike. This means investors buy the DJ EURO STOXX 50 Index and simultaneously sell a Eurex-traded DJ EURO STOXX 50 call option. This option has a one-month maturity and an exercise price set at 5% out of the money, meaning that the strike is worth 105% of the index level on a roll day.

In order to select the best strike we compute the various strategy payoffs at all possible final spot values, weighted by the probability that the spot moves to this final value. This is the expected return method or the return that the strategy should yield over a large number of cases. Of course, in any one case, the strategy may do as well as the maximum profit or as poorly as the maximum loss. Put in other words: if one constantly invests in positions with positive expected returns, one should have a better chance of making money. This approach seems relevant to us, in so far as the Buy Write strategy is embedded in a systematic strategy index, in the form of a 1M rolling strategy.

A correct expected return calculation must take into account all possible outcomes for the index at maturity, and it is important to have a reasonably accurate and consistent method of assigning the probabilities of these outcomes. For this purpose, we assume index levels are lognormally distributed, as in the Black & Scholes model. We use implied volatilities to model the distribution of final spot values at maturity, one month after the call sale.

When doing the maths at different dates in the past, we observe the expected return curve is at maximum for a 105% or 106% call strike, while this return is significantly lower for a 100% strike. As a conclusion, choosing a 5% Out-of-The-Money call vs an At-The-Money call seems to be a profitable choice.

How has the Buy Write Index performed?

A comparison with the long index strategy confirms well-known and long-established results: investors long on the DJ EURO STOXX 50 Buy Write Index would have significantly outperformed the benchmark on average. Since 2000, the DJ EURO STOXX 50 Buy Write Index has outperformed the DJ EURO STOXX 50 Total Return Index by 6.1% p.a. (if held 1M) and 7.0% p.a. (if held 2Y) on average. The DJ EURO STOXX 50 Buy Write index outperformed the DJ EURO STOXX 50 index during the 2000-2003 bear market. It also outperformed during certain periods of the 2003-2006 bull market, when its underlying index monthly return remained below 5% (the closer to the strike, the better). Since 2000, the DJ EURO STOXX 50 Buy Write Index volatility has been lower than the DJ EURO STOXX 50 Total Return Index volatility, with an average spread of 3 to 4 volatility points. Not only is the DJ EURO STOXX 50 Buy Write index realised volatility lower than the DJ EURO STOXX 50 Total Return index, but the spread is also an increasing function of the period from 6 months to 5 years. The volatility reduction is a patent feature of Buy Write strategy indices. This reduction is material in the case of the DJ EURO STOXX 50 Buy Write Index, even if the strike is 105%.