This Options Strategy Cushions Blow of Freefalling S&P 500by
S&P 500 down 7.4 percent in January as volatility jumps
Buy-write strategy tends to perform better in such markets
Here’s a way traders are cushioning losses in the stock market: selling bullish options that are unlikely to get exercised.
According to a gauge that tracks the strategy, known as buy-write, it’s working. The CBOE S&P 500 2% OTM BuyWrite Index, which mimics the hypothetical performance of the Standard & Poor’s 500 Index while selling calls, is at its highest levels since October 2014 relative to the benchmark. It’s outperformed the S&P 500 every year that U.S. stocks fell, according to data going back to 1988.
In a month marked by increasing stock swings and spiraling oil prices, options volume surged as traders sought to hedge their positions and bet on the trajectory of the market. Those who sold calls managed to mitigate the biggest monthly loss in U.S. equities since 2010 by generating income similar to a dividend. An exchange-traded fund tracking the strategy has seen inflows -- albeit tiny -- each month since October.
Scott Maidel, an equity-derivatives portfolio manager at Russell Investments in Seattle, says he’s seen growing client interest. The reason?
“Return enhancement, given their moderated view on equity upside potential, and also the cushion or lowering of portfolio volatility that these strategies provide,” he said. His firm oversees $237 billion. “Buy-writes can outperform long equity during periods of down, sideways or slightly up markets.”
Options trading on stocks, indexes and equity products rose to an average of about 19 million contracts each day this month, the most since the August selloff, according to the Options Clearing Corp. As traders rushed to buy protection, the cost of the derivatives climbed, with the Chicago Board Options Exchange Volatility Index surging 23 percent through Thursday. It dropped 6.5 percent at 10:38 a.m. in New York.
The buy-write strategy doesn’t always work, especially in bull markets. The CBOE index underperformed the S&P 500 between the low in 2009 and the end of 2014. Things changed last year, when the measure climbed 2.8 percent, as the S&P 500 fell. While both have have dropped this month, the buy-write gauge has lost less than the equity benchmark.
“These strategies have really been looked at very hard in the past year,” said Ronald Egalka, founder and adviser of Rampart Investment Management in Boston. His firm oversees $1 billion in options strategies. “Markets have become more volatile. And equally as important, you’re in a low-rate environment -- you’ve got investors starved for income.”
One caveat: there are many other ways of beating the market. For example, a gauge tracking defensive stocks -- those less affected by economic cycles -- has outperformed the S&P 500 this year and has fallen about two times less than another index tracking cyclical companies.