Option Series Pt. 3 – Aust Shareholders Association
posted on August 22nd, 2013 by Bellmont Research Team
We have arrived at the third and final part of our series on options. I hope this series, which introduces options, has shed some light on an unexplored area of investing. In this edition I will connect the concepts we have explored in the first two parts of this series and will introduce a simple options strategy that will lower your portfolio’s volatility and provide you with additional income.
The ‘holy grail’ of investing in equities is to generate a risk free return. Unfortunately we all know this cannot be achieved. It’s the reason why we invest in equities in the first place as we are willing to take more risk than say a term deposit, in the hope of generating a larger return. While it’s impossible to generate a risk free return from equities there are ways to lower your risk while still enabling you to generate a healthy return. One such strategy is the Buy-Write Portfolio.
As the name suggests the Buy-Write Portfolio consists of buying a portfolio of shares while at the same time selling (also known as writing) a monthly index call option. As we explored in the last edition of EQUITY, when you sell an option you receive a payment in the form of income in return for meeting the obligations of the option. Let’s consider an example to understand the benefits of this strategy.
In Richard’s SMSF he has a $300,000 long term share portfolio comprised of blue chip shares within the ASX 200. Some of his holdings include; CBA, ANZ, BHP, WBC, RIO, TLS, WDC, QBE, WOW & WES. Richard is frustrated with the constant volatility in the market so he decides to implement the Buy-Write Portfolio strategy. As the ASX 200 is currently at 5000 he decides to sell September 5100 call options for an income of $3000. What does this all mean? By incorporating an index option over his portfolio Richard has agreed to cap his potential capital gains at 5100 for the month of September (2% above the current price of 5000) in return for the certain income of $3000 (an income of 1% over his current $300,000 portfolio). The income generated cushions against share price falls and enhances returns in slowly falling, sideways, or slowly rising markets. Let’s examine Richard’s monthly return in varying market conditions.
As you can see from the table below, Richard’s portfolio has outperformed in all markets except the rapidly rising market where his returned is capped at 3%, a great result, but not quite the 4% the market achieved. What is worth noting however is the range of returns between the down market and rapidly higher market. The ASX 200 has a 5% range (-1% to 4%) where as the buy-write portfolio has a range of only 3% (0%-3%). By adding the option to his current portfolio Richard has been able to dramatically reduce his volatility while generating an additional income each month.
The Buy-Write Portfolio using index options is not a new strategy, numerous academic studies have been undertaken examining the success of the Buy-Write Portfolio strategy from both a return and risk perspective. The most applicable study for the Australian Market was a paper released in 2004 by SIRCA and the Capital Markets Cooperative Research Centre (CMCRC) which examined the Buy-Write Strategy involving the purchase of a portfolio underlying the S&P/ASX200 and simultaneously writing just out of the money S&P/ASX200 call options.
The study looked at a 15 year period from 31st December 1987 to 31st December 2002 and produced two key findings:
• The Buy-Write Portfolio outperformed the S&P/ASX 200 Accumulation Index (ASX 200 including dividends) by 2.23% per annum!
• The portfolio volatility was approximately 30% less than the underlying ASX 200 index.
If you wish to expand your knowledge on options or the Buy-Write Portfolio join one of our regular webinars at: Webinars and events
Full magazine – ASA Equity Magazine – September