Put Underwriting Has Similar Profile

Figure 5 above shows the profiles of a short call and of a long equity with an overwritten call. The resulting profile of call overwriting is similar to that of a short put (Figure 6 below); hence, call overwriting could be considered similar to stock replacement with a short put (or put underwriting).

Both call overwriting and put underwriting attempt to profit from the fact that implied volatility, on average, tends to be overpriced. While selling a naked put is seen as risky, due to the near infinite losses should stock prices fall, selling a call against a long equity position is seen as less risky (as the equity can be delivered against the exercise of the call).

Figure 6. Put Underwriting:

If a near zero cost 1×2 call spread (long 1×ATM call, short 2×OTM calls) is overlaid on a long stock position, the resulting position offers the investor twice the return for equity increases up to the short upper strike.

For very high returns the payout is capped, in a similar way as for call overwriting. Such positioning is useful when there has been a sharp drop in the markets and a limited bounce back to earlier levels is anticipated.

The level of the bounce back should be in line with or below the short upper strike. Typically, short maturities are best (less than three months) as the profile of a 1×2 call spread is similar to a short call for longer maturities.

Figure 7.:

Many investors call overwrite on single stocks. However, single-stock implied volatility trades more in line with realised volatility than index implieds. The reason why index implieds are more overpriced than single-stock implieds is due to the demand from hedgers and structured product sellers.

Call overwriting at the index level also reduces trading costs (due to the narrower bid-offer spread). The CBOE has created a one-month call overwriting index on the S&P500 (BXM index), which is the longest call overwriting time series available.

It is important to note that the BXM is a total return index; hence, it needs to be compared to the S&P500 total return index (SPXT Bloomberg code) not the S&P500 price return (SPX Bloomberg code).

As can be seen in Figure 8 below, comparing the BXM index to the S&P500 price return index artificially flatters the performance of call overwriting.

Figure 8. S&P500 and S&P500 1M ATM Call Overwriting Index (BXM):

Call overwriting performance varies according to conditions

On average, ATM index call overwriting has been a profitable strategy. However, there have been periods of time when it is has been unprofitable. The best way to examine the returns under different market conditions is to divide the BXM index by the total return S&P500 index (as the BXM is a total return index).

Figure 9. S&P500 1M ATM Call Overwriting Divided by S&P500 Total Return:

Overwriting underperforms in bull markets with low volatility

Since the BXM index was created, there have been seven distinct periods (see Figure 9 above), each with different equity and volatility market conditions. Of the seven periods, the two in which returns for call overwriting are negative are the bull markets of the mid-1990s and middle of the last decade.

These were markets with very low volatility, causing the short call option sold to earn insufficient premium to compensate for the option being ITM. It is important to note that call overwriting can outperform in slowly rising markets, as the premium earned is in excess of the amount the option ends up ITM.

This was the case for the BXM between 1986 and the mid-1990s. It is difficult to identify these periods in advance as there is a very low correlation between BXM outperformance and the earlier historical volatility.